MONETARY AND FISCAL POLICY 'Macroeconomics' Carlin ...
MONETARY AND FISCAL POLICY ‘Macroeconomics’ Carlin & Sosckice 2006 (Ch. 5-6, 8, 17.4) CHAPTER 5 Inflation, disinflation and deflation o Rising inflation If unions wield economic power, rising inflation reflects inconsistent claims on output per head in the economy o Very high inflation and hyperinflation Hyperinflation traditionally defined as inflation > 50% per month • Usually because governments can’t finance expenditure through normal means so monetary financing – seignorage • Some evidence that deterioration of economy associated with very high inflation paradoxically creates conditions for relatively painless subsequent stabilisation o Very high inflation means... Poor economic performance – depressed I, C and Y Short length wage contracts Increased use of foreign currency i.e. the nominal rigidities that are the one reason for costly disinflation virtually disappear but CB lacks credibility o Volatile inflation ‘volatile inflation is costly because it creates uncertainty and undermines the informational content of prices’ • Implies changes in real variables e.g. if money wages are indexed by past inflation and there is an unanticipated jump in inflation – real wages will drop • Real return on savings will fall as nominal IR only incorporates expected inflation • In sectors with rapid innovation, prices will be falling relative to other sectors with more stagnant technology • ‘volatile inflation masks the economically relevant changes in relative prices and therefore distorts resource allocation’ o Constant inflation – what level is optimal? Hypothetical circumstances when the constant rate of inflation shouldn’t matter too much: • If change is announced well in advance and tax system is indexed to inflation o Hence all real magnitudes remain unchanged o At high inflation, people wish to hold lower money balances, so for equilibrium in money market the real money supply must be lower than in the initial low inflation equilibrium Since... • At equilibrium output with low inflation, , we have: • and at equilibrium output with high inflation, , we have: • So, even while money wages, prices, the nominal money supply and nominal output rise, there has been an additional upward jump in the price level to bring down the real money supply to its new lower equilibrium level consistent with the demand for lower real money balances • Real costs of people economizing on money balances when inflation is high?
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o ‘shoe leather’ costs – more frequent trips to the cash machine o Menu costs – time and effort involved in changing prices – estimated to be quite low o Higher level of inflation tends to be more volatile o If we relax assumptions that indexation to inflation is widespread and adjustment to higher inflation is instantaneous (perfect information and low menu costs), costs of switching to high inflation economy become more substantial: Continuous reduction in living standards between wage adjustments – anxiety Unanticipated inflation shifts wealth from creditors to debtors Imperfectly indexed pensions and interest income from savings – makes the elderly poorer With any positive inflation rate, the real return on high powered money (notes and coins) turns negative – leads people to waste effort economizing on their money holdings (shoe leather) – inefficient o Following this argument, with a positive real IR, for the nominal IR to be zero inflation would have to be negative Friedman’s view of the optimal rate of inflation – the rate of deflation should = the real IR leaving the nominal IR = 0
o Deflation 2 main reasons why deflation not considered to be a good target: • Difficulty in cutting nominal wages – a positive inflation rate creates the flexibility needed to achieve changes in relative wages o Inflation’s role in ‘oiling the wheels of the labour market’ • The need for the CB to maintain a defence against a deflation trap o Can emerge when weak AD leads inflation to fall and eventually become negative. For this to happen: Need automatic self-stabilisers to be particularly strong Policy makers fail to stop prices falling o Attempts to use MP to stimulate economy result in nominal IR fall o Nominal IR close to zero and deflation implies positive real IR – may be too high to stimulate private sector demand o Once deflation takes hold, it can feed on itself Monetary policy paradigms o IS/LM paradigm – monetary policy is passive (in the form of a fixed growth rate of the money supply) ‘Keynes effect’ does the work of raising the IR – rising inflation relative to a fixed money supply growth reduces real money balances and leads to portfolio adjustment with bonds being sold – pushes bond prices down and IR up o MR paradigm – monetary policy is active (raises IR in response to a rise in inflation due to an increase in output) o Poole (1970) If economy is characterised by LM shocks a fixed IR is better for output stability than a fixed money supply, converse holds for IS shocks Shows that an active MP is normally superior to a passive one when the economy is characterised by shocks and lags in adjustment o Friedman, the most famous proponent of the use of the money supply as a policy target by the CB, has conceded that ‘the use of the quantity of money as a target has not been a success.’ He added ‘I’m not sure I would as of today push it as hard as I once did’ (Financial Times, June 2003) The monetary policy rule in the 3 equation model o Aim to explain the role of the following variables: CB’s inflation target = CB’s preferences = β
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o ‘shoe leather’ costs – more frequent trips to the cash machine o Menu costs – time and effort involved in changing prices – estimated to be quite low o Higher level of inflation tends to be more volatile o If we relax assumptions that indexation to inflation is widespread and adjustment to higher inflation is instantaneous (perfect information and low menu costs), costs of switching to high inflation economy become more substantial: Continuous reduction in living standards between wage adjustments – anxiety Unanticipated inflation shifts wealth from creditors to debtors Imperfectly indexed pensions and interest income from savings – makes the elderly poorer With any positive inflation rate, the real return on high powered money (notes and coins) turns negative – leads people to waste effort economizing on their money holdings (shoe leather) – inefficient o Following this argument, with a positive real IR, for the nominal IR to be zero inflation would have to be negative Friedman’s view of the optimal rate of inflation – the rate of deflation should = the real IR leaving the nominal IR = 0
o Deflation 2 main reasons why deflation not considered to be a good target: • Difficulty in cutting nominal wages – a positive inflation rate creates the flexibility needed to achieve changes in relative wages o Inflation’s role in ‘oiling the wheels of the labour market’ • The need for the CB to maintain a defence against a deflation trap o Can emerge when weak AD leads inflation to fall and eventually become negative. For this to happen: Need automatic self-stabilisers to be particularly strong Policy makers fail to stop prices falling o Attempts to use MP to stimulate economy result in nominal IR fall o Nominal IR close to zero and deflation implies positive real IR – may be too high to stimulate private sector demand o Once deflation takes hold, it can feed on itself Monetary policy paradigms o IS/LM paradigm – monetary policy is passive (in the form of a fixed growth rate of the money supply) ‘Keynes effect’ does the work of raising the IR – rising inflation relative to a fixed money supply growth reduces real money balances and leads to portfolio adjustment with bonds being sold – pushes bond prices down and IR up o MR paradigm – monetary policy is active (raises IR in response to a rise in inflation due to an increase in output) o Poole (1970) If economy is characterised by LM shocks a fixed IR is better for output stability than a fixed money supply, converse holds for IS shocks Shows that an active MP is normally superior to a passive one when the economy is characterised by shocks and lags in adjustment o Friedman, the most famous proponent of the use of the money supply as a policy target by the CB, has conceded that ‘the use of the quantity of money as a target has not been a success.’ He added ‘I’m not sure I would as of today push it as hard as I once did’ (Financial Times, June 2003) The monetary policy rule in the 3 equation model o Aim to explain the role of the following variables: CB’s inflation target = CB’s preferences = β
