Toughworld Summary sample essay

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There has been a continuing gap between the headline inflation rate and the core inflation rate in the United States for years. Headline inflation for 2007 was 4.3% in the US and 3.1% in the European Union. However, the gap between headline and core inflation rate is much larger in US than in EU. The core rate excludes volatile-priced items as food and energy.

The worldwide increase in commodity prices is the pointed cause for this rise in headline inflation. This is evidenced by the Goldman Sachs broad commodity index increase by 288% over the last six years, with the energy and industrial metals indexes exhibiting the same trend and increasing by 358% and 263%, respectively. Moreover, the recent devaluation of the dollar intensifies the impact of commodity price increases on headline inflation. This relative rise in commodity prices may indicate inflationary pressures and may even cause inflation. Deflating this commodity prices increase by the unit value increase of manufactures exports, the relative real prices for commodities, energy, and industrial metals have increased by 147%, 192%, and 131%, respectively.

There is therefore a global increase in the relative prices of commodities, especially energy, compared with manufactures. Possible reasons include: (1) increasing demand for industrial raw materials and oil in emerging economies, especially China, (2) increased demand for agricultural products from biofuels production pressures, (3) supply cuts from bad harvests, higher costs, and insufficient investment, and (4) higher agricultural production cost from rising energy cost.

This huge commodity price increase has implications for drafting monetary policy: (1) raised inflation measure and (2) decreased output, demand, and aggregate real income. Though the predominating effect is unknown, the general rules for monetary policy-drafting are threefold: (1) monetary policy cannot return the eroded real income resulting from higher prices, (2) banks should ignore temporary price fluctuations to prevent economic instability, and (3) response is necessary for prolonged, constant price increases to contain inflation expectations.

Higher inflation expectations might result to the failure of or negative impact of aggressive monetary policy. Short-term rates have been lowered to avert a probable crisis but long-term rates have risen instead of followed the downward trend. Expected inflation is actually soaring and the Fed cannot cut rates further without any consequences. To prevent an economic downturn, central banks should cut rates if commodity prices are predicted to be unchanged or fall, something the growth of emerging economies cannot promise.

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