The Crude Art of Policymaking

Essay by turtle2179University, Bachelor'sA, February 2005

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The article I have chosen to analyze is from printed on June 10, 2004. The title of the article is the crude art of policy making. This article discusses weather the central banks should respond to the rise in oil prices by increasing interest rates. It indicates how inflation is on a rise from 1.6% in February to 2.5% in May. It is expected that inflation will rise to over 3% shortly. They blame this rise on inflation on higher oil prices as they rose about 25% over a year ago.

The article indicates that higher oil prices hurt the oil-importing economy in two ways. First, it increases production and reduces profits. Therefore it supplies fewer goods and services at a given price. Second, the higher oil prices transfer the income from oil importing counties to the oil producers. This causes a negative supply shock and a negative demand shock in the economy.

This shock causes higher oil prices and pushes up inflation. The article states that it depends upon how monetary policy reacts and how the demand curve for oil ends up. An example shown is how policy reacted after the 1973-74 oil price increase reacted. To prevent output falling, America's federal funds rate was cut from 11% to 6% during this time. This resulted in sharply negative real interest rates. This causes the demand curve to increase, with the aim to support the output. As a result the prices increased. In order to bring inflation down, the central banks had to increase the rate rapidly, which later caused a deeper recession. After learning this valuable lesson in the 1970's the central banks raised interest rates after the oil prices went up in 1979-80 and 1990-91. This was done in order to hold inflation down.

The lesson...