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For countries with prospering economies such as the US, inflation can usually set in due to one main reason, an overheated economy. For most of us the picture of an expanding economy can be nothing short of thrilling. An expanding economy is usually identified with higher corporate profits, low unemployment, and improved wages: the right mix for prosperity. In an expanding economy crime rate falls, government services improve, and all around the stage is set for a higher quality of life. Then an accelerated economic growth should be even better. Right? Well as we saw in the last section the answer in most cases is no.

Pre-emptive Strikes

If all this talk about recession and inflation has gotten you down, you are not alone, and that is a good thing. History has shown time and time again that just when people start believing that nothing could go wrong with the economy, the economy goes wrong.What this means is that a little bit of paranoia is necessary to constantly check and re-check the economy for any initial signs of trouble. So what can be done to keep the economy from deviating from its right course? The answer lies in the central bank: yes, the Federal Reserve.

In the US, the Fed possesses a set of tools and the authority to use them in order to nudge the economy back to its right course should there be any indication of trouble. Together these tools comprise the Monetary Policy which we discussed in detail earlier. The Fed tightens its Monetary Policy to stem inflation and loosens it to battle recession. As you may guess the Fed must play a difficult balancing act in order to achieve its objectives. Taking actions that are too strong, too weak, too soon, or too late could have disastrous results for the economy. For example, if the Fed senses a hint of an inflationary condition, it should react with tightening of the Monetary Policy at a precise time with a …