Research Paper about Inflation
In October of 2021 inflation hit a high that had not been seen in almost 3 decades. Prices for energy and food were the most prevalent to increase from last October to this year (Elving 2021). Inflation is the general decrease of the purchasing power of money and an increase of goods and services prices. Since the consumer price index1 (CPI) was released, many economists accredit this high to the COVID-19 pandemic and its underlying effects. A published article written by Ron Elving reports on the recent inflation surge by looking back at recent history and how it impaired previous presidents. The core purpose of this paper is to look at modern history and review the macro-economic factors past presidents additionally had to experience because of high inflation.
Looking at the Past
Jumping back to the early 1970s President Richard Nixon was in the mist of The Vietnam War, which he knew would eventually lead to inflation motivated by overspending during the war and social programs put in place a decade before. During his first year as president the CPI rose to 5.8% and rose another .3% his second year to 5.8% (Elving 2021). Due to this the Federal Reserve Board (the Fed), which is the central bank of the U.S. and operates to successfully run and promote the U.S. economy, (Board of the Governors of the Federal Reserve System, 2021) implemented a restrictive monetary policy. This implementation saw a decrease in the money quantity in the economy, which adjacently decreased the Gross Domestic Product (GDP) of the country. Nixon opposed this decision so in August 1971 he enacted price and wage controls which were celling’s put in place to limit the increase in both price and wages to help restrain inflation. While in the short run his income policy worked and helped keep inflation at just 3% in 1972, but by 1973 the policy had concluded, and the CPI had doubled to 6.2% and by 1974 it had jumped to 11.1% (Federal Reserve Bank of Minneapolis, 2021). Nixon was never able to salvage the inflation that was plaguing the country due to his resignation in 1794.
Nixon was promptly followed by his vice president, Gerald Ford. President Ford promoted an initiative called “Whip Inflation Now” or WIN (Elving 2021). WIN advocated for citizens to make disciplined fiscal decisions; this untimely didn’t do much as inflation still averaged around 9% during his term hitting a peak of 12% as well. (Elving 2021).
After Ford ultimately failed to get inflation under control, President Jimmy Carter was elected president during a time known as “stagflation” which is defined as “a period of inflation with declining economic output” (Garber 2021). Because of the oil price shock that took place because of oil workers going on strike, inflation and unemployment rates were back up in the double digits during his term. Carter appointed Paul Volcker chair of the Fed, with Volcker’s new power he raised banking interest rates very steep with the intent to drain investments and hit economic growth (GDP). Many Americans lost their jobs and business were hurt because of this policy, although Volcker’s knew the implications, his plan was to confront inflation head on to get inflation and unemployment under control.
With another president defeated and out the door, President Regan was elected and was the new voice of reason for the economy. Although unemployment and loans reached levels not seen since the Great Depression just like his predecessor, Regan stuck with Volcker and by 1983 inflation rates began their fall (Elving 2021). As inflation slowly fell so did the interest rates and it wasn’t long after that unemployment rates were dropping too.
Back in the present the 6.2% inflation jump is the highest we have seen since 1990 when President George H.W Bush organized a union to evacuate the Iraqis from Kuwait that were disrupting the oil market of the world. Due to this conflict a global recession was felt heavily in the U.S.
Is Present Day Inflation Substantial?
In the Article “Inflation is at 30-year highs. Here's how it's hurt past presidents” the writer does acknowledge a high in inflation rates in present day times, but there are some who argue that there is no significant inflation in sight. Some compare the pandemic to a genuine warfare, the kind of combat that usually does lead to inflation like the Vietnam War for example. Nevertheless, the great difference between these two fights is the actual crash of the supply chain in an economy due to shortages that rise the prices in an actual war. The pandemic a “figurative war” being fought on the other hand has left this whole side of the economy intact, during the pandemic the opposite occurs where demand takes most of the hits. Chief Asia Pacific economist, Alicia Garcia Herrero says, “Capital is not destroyed or depleted, so it is much easier to end up with excess,” meaning industries can produce more than is being produced now being that inflation is low.
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Term Paper on Inflation: Top 6 Papers | Money | Economics
Here is a compilation of term papers on ‘Inflation’ for class 9, 10, 11 and 12. Find paragraphs, long and short term papers on ‘Inflation’ especially written for commerce students.
Term Paper on Inflation
Term Paper Contents:
- Term Paper on the Control of Inflation
Term Paper # 1. Meaning of Inflation:
A rise in price level or fall in the value of money is often the result of the excessive amount of money, or excessive issue of paper currency and this is commonly referred to as inflation.
The various economists have defined inflation as follows:
“Inflation is a general and continuing increase in prices. This does not imply that all prices are increasing, some prices may even be falling, and the general trend must be upward. The rise in prices must also be continuing; once and for all price increases are excluded.” – Michael R. Edgmand
“We define inflation as rising prices, not as high prices. In some sense, then inflation is a disequilibrium state.” – Gardner Ackley
“By inflation we mean a time of generally rising prices for goods and factors production- rising prices for bread, cars, haircuts, rising wages, rents etc.” – Paul A. Samuelson
“Inflation is a state in which the value of money is falling or prices are rising.” – Crowther
“The obvious definition of inflation is that inflation is a rising price level” – Edward Shaoiro
“Inflation is a self-perpetuating and irreversible upward movement of prices caused by excess of demand over capacity to supply.” – Emile James
“Inflation consists of a process of rising prices.” – A.C.L. Day
The well-known English economist John Maynard Keynes has clearly distinguished between two types of rise in the price level in a country:
(a) Rise in prices followed by increase in production and employment; and
(b) Rise in prices not followed by such an increase in output and employment.
If a country is working with a large number of men unemployed, and a large number of factories, workshop etc. not fully utilised, any expansion of money and consequent increase in demand for goods and services will result in the rise in the price level and also rise in the production of goods and services.
This type of increase in production and in employment will continue so long as there are unemployed men and materials i.e., till the stage of full employment. Keynes states that the rise in the price level upto the stage of full employment is a good thing for the country since there is an increase in output and also in employment. Reynes uses the term reflation for such a rise in the price level.
The rise in the price level after the state of full employment is bad for the country since there is no corresponding increase in production and employment. Inflation is used to refer to such a rise in the price level after the economy has attained full employment in development countries like, India there may be heavy unemployment and under-employment and economic resources may not be fully employed.
In such economies, rise in the price level may not lead to increase in production and employment because of certain constraints in production as, for example, shortage of technical and managerial skill, shortage of power, transport etc. (known as bottle-necks). Hence, India can experience inflationary rise in prices even though it has not reached a stage of full employment.
Term Paper # 2. Kinds of Inflation :
(i) demand pull inflation:.
This represents a situation where the basic factor at work is the increase in demand for resources either from the government or the entrepreneurs or the households. The result is that the pressure of demand is such that it cannot be met by the currently available supply of output. If, for example, in a situation of full employment, the government expenditure or private investment goes up this is bound to generate an inflationary pressure in the economy.
(ii) Cost Push Inflation:
In certain cases, prices may be pushed up by rise in wages or rise in profit margins. Often higher commodity taxes imposed by the government will raise the cost of production and therefore, raise the prices of goods and services. Thus, rise in wages, profit margins, and taxation all these are responsible for cost-push inflation.
(iii) Open or Suppressed Inflation:
A country might experience open or suppressed inflation. Open inflation refers to a situation where prices rise without any interruption. It is a situation where government does not make any attempt to stop rising prices. Suppressed inflation, on the other hand, is the one where government actively intervenes to check rising prices through price-ceiling, rationing or otherwise. Private holdings of cash and bank balances increase during the suppressed inflation. Prices will not rise in the controlled sector.
(iv) Money Inflation and Price Inflation:
Money inflation occurs in the initial stage. There is an expansion in the money supply during the initial stage leading to a sharp rise in the price level. Price inflation is the next stage when the rapid rise in demand leads to an enormous increase in the money supply. During this stage, the money supply fails to keep pace with the rate of increase of price level. Prices rise rapidly and the money supply lags behind in this stage of inflation.
(v) Wage Induced and Deficit Induced Inflation:
Inflation may also occur on account of the increase in money wages. Money wages have a tendency to increase whenever prices rise. Strong trade union may force employers to increase wages. This results in increased cost of production without any increase in output. This lead to further rise in price. Such type of price rise is called the wage induced inflation.
Deficit-induced inflation, on the other hand, occurs when the governments resort to deficit financing. Sometimes the government is not in a position to meet its expenditure by taxation i.e., its expenditure is more than income. The government then resorts to deficit financing. To finance deficit, government may increase the money supply by printing new currency notes. This results in rising prices. Wherever prices increase due to deficit financing, we call it deficit induced inflation.
(vi) Creeping, Walking, Running and Galloping Inflation:
This classification is made on the basis of the extent to which prices rise. Creeping inflation is the mildest type of inflation. Prices rise very slowly. They increase by about 2 to 3% p.a. Such type of inflation is not at all dangerous to the economy. In fact, some economist Price income suggest that such type of inflation has 15% to be encouraged to make the economy dynamic.
But if the prices start rising 10% gradually at the rate of 3 to 5 per cent p.a., the situation is called the walking 3 to 5% inflation. If proper control is not exercised over this type of inflation, it 2 to 3% may turn into what is known as 0 Years running inflation. During running inflation, the rate of increase in the price level gets further accelerated. The price level under this type of inflation rises approximately by 10 per cent every year.
In case government fails to curb running inflation in time, it may easily develop into a galloping or hyperinflation. Hyperinflation is the most reverse type of inflation. Prices rise rapidly and perhaps there is no limit to which prices may rise. This type of inflation was experienced by India during the Janta Dal government regime (1989-91). At the time the rate of inflation was 17% approximately. The above classification of inflation into creeping, walking, running and galloping inflation can be better explained with the help of Fig. 12.1.
(vii) Comprehensive and Sporadic Inflation:
Inflation is also classified into comprehensive and sporadic inflation on the basis of coverage and scope. Comprehensive inflation is an economy-wide inflation. It occurs when the entire economy experiences inflationary pressures. Prices of all commodities rise in the economy. Price rise is not confined to any particular sector. It extends to every sector in the economy. It is normal inflationary phenomenon and refers to the rising prices of the general price level.
Sporadic inflation on the other hand is sectorial in nature. It refers to a situation wherein inflation is experienced by certain sector of the economy. It may occur on account of restricted supply of certain commodities due to certain specific reason like crop failure resulting in the price rise of food-grains or formation of a successful monopoly in the manufacturing sector causing price rise only in the manufacturing sector. Sporadic inflation is thus confined to only certain sectors in the economy.
Term Paper # 3. Nature, Features and Characteristic of Inflation :
Characteristics and features of inflation are as follows:
1. Inflation is an economic phenomenon. It is the result of economic forces.
2. Inflation is also a monetary phenomenon. Excess supply of money may cause inflation.
3. Cyclical movement is not inflation.
4. The hall mark of inflation is excess demand in relation to everything.
5. Inflation is a dynamic process which can be observed only over a long period of time.
6. It is always associated with an uninterrupted rise in prices.
7. Price rise is persistent and irreversible immediately. It is different from temporary price rise.
8. Pure inflation is a past full employment phenomenon.
Term Paper # 4. Causes of Inflation:
Inflation in an economy arises on account of number of factors. These factors relate mainly either to the demand or to the supply side. By demand we mean the demand of money income for goods and services and by supply we imply the available output for which the money income can be spent. Expectations also play an important role in causing inflationary pressures in the country.
Therefore, the factors that cause inflation may be divided into three groups:
(i) Demand Factors:
Increase in demand may be due to:
(а) Increase in disposable incomes.
(b) Increase in community’s aggregate spending on consumption and investment goods.
(c) Excessive speculation and tendency to hoarding and profiteering on the part of producers and traders.
(d) Increase in salaries, wages or dearness allowance.
(e) Increase in foreign demand and hence exports.
(f) Increase in population.
(g) Increase in money supply.
These causes may operate singly or in combination with one another. Generally, the most important cause of inflation is excessive public expenditure financed by deficit financing during war or on the implementation of plans for economic development. The newly created money increases government demand for goods and services and also the purchasing power of the people through increase in disposable income.
(ii) Supply Factors:
No corresponding increase in the output of goods and services may be due to:
(а) Increase in exports for earning the required foreign exchange.
(b) Draught, famine or any other natural calamity adversely affecting agricultural production.
(c) Deficiency of capital equipment.
(d) Scarcity of other complementary factors of production e.g., skilled labour or technicians, essential raw materials or lack of dynamic entrepreneur.
(e) Speculative hoarding by the producers, traders and middlemen in anticipation of a further rise in prices.
(f) Prolonged industrial unrest resulting in reduction of industrial production.
(iii) Role of Expectation:
Inflation cannot be explained only in terms of excessive spending relative to available output. Expectations play an important role in the speed of inflation. Expectations regarding future movement of prices and wages result in the inflationary pressure in the economy. When prices are expected to increase, consumers will purchase more goods.
This will lead to an increase in the price level. Similarly, a rise in the expected income induces people to spend more. Expected wage increases also bring about inflation in the country. Expectations thus play a vital role in causing inflation in an economy.
Term Paper # 5. Effects of Inflation :
Inflation indicates the rise in the price level and a fall in the value of money.
The effects of inflation can be broadly classified under following three categories:
(i) Political Effects of Inflation:
Inflation also leads to political upheavals. Political indiscipline grows and corrupt practices become common. Hitler became dictator of Germany only because of hyper-inflation during 1920s. Political revolutions are the outcome of inflationary rise in prices. Political and economic speculations are encouraged by inflation. Political stability is disturbed by inflation.
(ii) Economic Effects of Inflation:
Economic effects of inflation can be studied under following two heads:
(a) Effects on Distribution of Income:
Inflation redistributes income because prices of all factors do not rise in the same proportion. The effect of inflation on the incomes of different classes of earners is not uniform.
Following classes of people are affected by it:
1. Working Class:
Wages do not rise as fast as the prices rise during inflation. Naturally, workers tend to lose during the period of rising prices. The trade unions try to bargain with their employers for higher wages. Still the rise in wages is not corresponding to a rise in the prices. So, the workers are adversely affected during inflation. Salaried people have a more harsh effect of inflation than the wage-earners as they are not organised like the salaried people.
Inflation reduces the consumption of people. Rising price reduces private consumption by reducing the purchasing power in the hands of the people. The resources left unused can be secured by the government by printing new currency notes or raising the public debt. Thus, inflation can transfer the resources from the public to the government.
The reduced consumption of the public or increased savings is termed as the phenomenon of forced savings. Forced savings have been made use of by many countries for their economic development. However, consumers have to lead a low standard of living in the initial stages of development.
The effects of inflation have been nicely concluded by Kenneth K. Kurihara in the following manner:
“Inflation redistributed wealth and income in such a way as to hurt consumers, creditors, small investors and low and fixed income group, and benefits businessmen, debtors and farmers.”
3. Renteir Class:
People whose incomes are fixed (the rentier class) viz., pensioners, annuity holders, people living on past savings, etc., suffer the most during inflation. Inflation causes the real income of these people to fall due to rising prices. Falling real income reduces their standard of living. Inflation is thus harmful to the rentier class.
4. Debtors and Creditors:
Debtors as a group are benefitted during inflation whereas the creditors are put to loss. The debts are always fixed in terms of money in the modern economy. When a person borrows money before rise in the price level and repays later when prices have risen, he pays back the same amount of money but definitely having less purchasing power. Creditors are at a loss during inflation as they receive money having less purchasing power.
Farmers are benefitted during inflation because of two factors:
(a) The price of farm products increase; and
(b) Increase in the cost of production lags behind the rise in the prices.
Farmers who produce food-grains and other highly inflation-sensitive products are benefitted the most. Farmers in debts repayment repay their old debts along with the rate of interest as they get profits due to rising prices. They are further benefitted as debtors as they pay back lower purchasing power to the creditors. Inflation thus provides double advantages to the farmers.
6. Business Community:
The manufacturers, merchants and entrepreneurs stand to gain during inflation. The value of stocks held by the merchants increases during inflation. Business community sells commodities at better prices and earns high profits. Entrepreneurs earn huge profits as the rise in the price will be more than the rise in the cost of production. Producers try to increase the price in the cost of production instead of reducing their margin of profits. Inflation has favourable effect on the business community.
Inflation is favourable to those who invest in equities, but is rather harsh to those who invest in fixed interest yielding bonds. Equity dividends increase during inflation due to increased corporate earnings and investors in equities are benefitted. Fixed interest yielding bonds bring the same income but less purchasing power.
Institutional investors safeguard their interest by diversifying their resources in profitable investments, but small and middle class investors lose much. In many countries small investors have experienced heavy losses because of the fall in the purchasing power of money. The fall in the value of money discourages saving and therefore, reduces the volume of funds available for investment in a free market economy.
(b) Effects on Production:
Keynes is of the opinion that a moderate rise in prices i.e., mild or creeping inflation has a favourable effect on production when there are utilised or underemployed resources in existence in an economy. Such a rise in prices creates optimism among the business community as they get more profits with increasing prices. They are induced to invest more and as a result employment, output and income will increase. The limit is set by the full employment level.
Once the full employment stage is reached in the economy, a further rise in the price will not stimulate production, employment and income due to physical limitations. So, till the level of full employment is reached, moderately rising prices are beneficial. The beneficial effects on production are possible only when inflation is moderate. A state of running or galloping inflation creates a lot of uncertainty which is harmful to production.
(iii) Social Effects of Inflation:
Inflation not only creates economic effects but also leads to certain social effects. It brings down the standards of business morality by encouraging a few rich persons. Black-marketing, anti-social activities dominate the society during inflationary rise in prices. Social peace is disturbed.
Frustration exists among poor people. It likely result in a social revolt. Social atmosphere gets totally spoiled as rich men try to exploit the situation and take undue advantage of inflation. Social stability is at stake. Unfair practices and social discontent become order of the day. Patriotic people are penalised.
Term Paper # 6. Control of Inflation :
Inflation is very complex phenomenon. There is no one sovereign remedy to combat it. On the other hand, measures have to be taken on several fronts, monetary and nonmonetary, to fight it. All these measures have one common aim. They aim at reducing aggregate monetary expenditure taking the available output as given.
Broadly speaking, the anti-inflationary measures can be classified as under:
(i) Monetary Measures:
According to some economists, inflation is a monetary phenomenon, i.e., it is caused by the monetary factors. These economists suggest that the control over the supply of money is the best measure to combat inflation.
The anti-inflationary monetary policy refers to the central banking operations of restricting credit. The Reserve Bank of India makes use of its weapons like the bank-rate policy, open market operations, variable reserve ratio and the selective credit controls to restrict credit. The monetary policy can successfully control inflation only when it is caused by the excess supply of money.
(ii) Fiscal Measures:
The two wings of fiscal policy are government revenues and government expenditure. The government’s fiscal policy can contribute to the control of inflation either expenditure, but decreasing government expenditure or combining both the elements. If private spending tends to excessive, the government can moderate the inflationary pressure by reducing its own reduction or postponement of government expenditure in modern times is not an easy task.
There may be projects already under construction and these obviously cannot be postponed. Similarly, other types of expenditure may be necessary to meet the normal requirements of the ‘collective consumption’ of the community-defence, police, justice etc. Then, there may be social expenditures on education, health etc., which are very difficult to cut because of undesirable political effects. Therefore, the major emphasis of fiscal policy in inflation has been a reducing private spending through increased taxation.
An increase in taxes tends to reduce private spending. If the rates of direct taxes on incomes and profits are raised, the private disposable income is reduced and this will tend to reduce private consumption spending. If the rates of commodity taxes are increased or fresh levies are made, the effect on consumption will be more immediate. An increase in the tax rates on a commodity will penalise spending directly by raising the cost of purchases.
Thus in period of inflation, the government should curb its own spending and increase the tax rates to reduce private spending. It is good thing to plan for a budget surplus during inflationary periods.
(iii) Other Measures:
There are also other physical measures to control inflation. For instance, government may try to increase output and thereby control inflation. In countries, like India where inflation is because of the shortage of agricultural commodities, it can be controlled by increasing the output of agricultural commodities.
Even in developed countries, by changing the techniques of production, the level of full employment output can itself be increased and be adjusted to the increased aggregate demand. There may be physical restraints on the increase in output and, therefore, we have to note the problems of technique, availability of factors of production in increasing output.
Inflation may also be due to the speculation activities, business expectations and hoardings. Under such circumstances, the government may try to restrict speculative activities to control inflation. In India, in order to protect the consumers from the evils of speculative activities, the government of India has given greater importance for the distribution of essential commodities through consumers’ co-operatives.
If the rise in the price confined only to some commodities the government may try to control their prices through price controls and rationing of the scare commodities. Rationing and price controls suffer from a severe limitation viz., coercion cannot be extensively made use of in a democratic country.
Lastly, if the inflation is due to the increase in cost (cost-push inflation), it can be controlled by wage freeze. The Government may try to put an end to the wage price spiral by freezing wages. This policy becomes effective if the trade unions do not object to the control over wages. Further, if the government wants to control wages, prices should not be allowed to rise, so that the standard of living of the consumers is not adversely affected.
Term Paper , Economics , Money , Inflation , Term Paper on Inflation
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International Review of Applied Economics
Economic development and inflation: a theoretical and empirical analysis
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2. economic development and inflation, 3. the structure of the model, 4. methodology and empirical framework, 5. concluding remarks, disclosure statement, acknowledgements, review article.
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This paper studies the relation between inflation and economic development. The literature is largely silent regarding both the theoretical and empirical perspectives that undeveloped countries endure higher average inflation than developed economies. We present a simple theoretical model linking the inflation phenomenon to the tradition of development economics. Empirical evidence is garnered to test the hypothesis that economic development engenders a downward bias to inflation rates. Through the feasible-GLS estimator in a panel of 65 countries from 2001 to 2011, we aim at listing a number of variables most commonly used to explain differences in the stage of economic development across countries and identifying the most statistically relevant ones to account for differences in inflationary patterns. While our results show that inflation is inversely correlated with the level of the technological content of the economy (measured by share of high-tech exports), human capital and cyclical unemployment, it is directly related to the degree of inflation persistence and terms of trade growth. However, our findings still present an inverse and low correlation between inflation persistence and economic development, implying that development-sensitive variables allowed into the model can only partially account for the differences in inflation at different levels of economic development.
- Economic development
- FGLS estimator
After long-lasting theoretical debates between the 1970s and late 1990s, the academic literature on inflation has reached a fair range of consensus (see Goodfriend and King Citation 1997 ). Despite some dissent regarding the specific causes and channels through which inflation is worked out into the system, it is generally accepted that inflation is caused by three primal causes: (i) excess aggregate demand over supply is a typical feature of overheated economies at full-employment of productive resources; (ii) the cost-push effect that could result from upward changes in the market power enjoyed by oligopolistic domestic companies, rising unit labor cost, increased prices of imported intermediate inputs, and one-time or systematic shortages of productive resources in general – due to droughts, wars, etc. – thereby swelling costs that feed through into prices of consumption goods; (iii) finally, a self-feeding component by way of an autoregressive mechanism imbued in distributional conflicts among social groups; persisting conflict is likely to crystalize in economic institutions practices such as indexation and other systematic revisions of prices, wages and rents that incorporate occasional shocks to inflation trends. Therefore, understanding, predicting and taming inflation usually involve a weighted combination of these three central forces. Conventional policies are biased toward a demand-based diagnostics of rising prices while heterodox policy-prescriptions are mostly grounded on cost-related and institutional forces due to the recognition that firms in modern economies tend to operate with excess capacity.
Notwithstanding this established wisdom, one might wonder about the extent to which these forces explain inflation in different economies. Are local features particularly relevant to account for differences in the magnitude of parameters mediating between these inflationary forces and the response by price indexes? Does historical and institutional variety imply qualitative differences among countries as to the behavior of inflation? As illustration of this point, one could recall that cost structures vary widely across the development spectrum due to labor market regulations, exchange-rate volatility and so forth. These are questions not easily addressed in simple and reductionist frameworks. However, daunting may be such a challenge, their implications are clear and should provide enough motivation for any effort in this direction, namely: policy could be improved by taking heed of disregarded nuances and mechanisms, should other forces prove significant in accounting for inflation. Simply stated: inflation control is likely to require more than vigilant and rigorous monetary policy. By overlooking the existence of a broader array of development-related forces accounting for different inflationary behaviors, current academic knowledge is likely to poorly inform both the public and policy-makers who hold a stake in this matter.
This paper tackles these questions by formalizing and testing the existence of a relation between economic development and inflation. The literature has been largely silent on this issue, despite the fact that simple descriptive statistical analysis supports the empirical notion that undeveloped countries endure higher average inflation than developed economies. The argument is organized in four sections beyond this introduction. The second discusses the relation between inflation and economic development. Section 3 presents the theoretical model undergirding the empirical analysis, which is the object of Section 4 . The last section concludes the paper pointing out limitations and a future research agenda on this topic.
The recent empirical literature on development economics has consistently overlooked the connection between economic development and inflation. Most studies undertake the task of verifying correlations between inflation and growth. Even so, the only study on the matter seems to be Bruno and Easterly ( Citation 1998 ), which have found no such correlations between growth rates and inflation in a sample of countries, although they were mostly focused on high inflation experiences. Footnote 1 The fact that the majority of countries managed to curb inflation in the 1990s – and to keep it under control ever since – paved the way to the notion that an era of ‘Great Moderation’ had finally begun (Rogoff Citation 2003 ). The theoretical problem of inflation has thus become indelibly detached from development concerns.
Difference in inflation rates among countries is then frequently – and squarely – ascribed to credibility of governments, the quality of institutions of monetary policy, practical arrangements in Central Banking and technical aspects of inflation indices (see IMF (International Monetary Fund) Citation 2016 ; chapter 3; Rogoff Citation 2003 ; Romer and Romer Citation 1997 ). Notwithstanding the truth they convey, these elements overlook shared economic and structural features related to each country’s stage of development. Underlying institutional aspects of economies that explain various development trajectories are likely to play a significant role in macroeconomic performance and volatility (Acemoglu, Johnson, and Robinson Citation 2001 ; Acemoglu et al. Citation 2003 ; Acemoglu and Robinson Citation 2012 , chapter 11–12). The empirical divide regarding the inflationary behavior between high income and upper middle-income countries observed in the data is a real phenomenon yet in search of a theory. Footnote 2 However, the difficulties in building one are quite daunting, for it must take heed of the productive structure, degree of openness, distributive profiles (policy-induced and otherwise), as well as several institutional and historical specificities. These aspects taken together may reveal deep-seated sources of downward inflexibility of prices, which add up to – and enhance – the more close-to-surface mechanisms affecting the level of inflation.
At variance with the conventional literature, we point out that inflation is not strictly a matter of sound monetary policy and a rigorous control of government finances. Our work contributes to the literature by claiming that inflation might be also correlated with the stage of development of a given country. Were it not the case, undeveloped countries focusing its policies on price stability would receive pressure by Bretton Woods institutions to rapidly seek 1–2% inflation rates. This does not seem to be the case, for it is only suggested as an ‘eventual’ goal to be achieved. Besides, targets should be determined, it is advised, according to local economic reality (Fischer Citation 1997 , 16). Footnote 3
As a result, no empirical study, to the best of our knowledge, has been able to account for what simple descriptive statistics reveal, namely, that low- and middle-income countries are prone to have higher inflation scores than high-income countries (see Figure 1 ). One possible explanation for such a gap in the literature may be the difficulty in deriving general statements from country-specific empirical data. This is hardly any surprise. There is a high variance of inflation scores within these low- and middle-income sub-samples, which clearly owes to their heterogeneous institutional and productive frameworks.
Figure 1. Inflation Rates for Country Groups classified according to income levels – 1996–2013.
In what follows, a uniform theoretical approach explores the link between inflation and structural changes, spelling out the channels through which the development process affects the economy’s price-output dynamics and, therefore, a country’s inflation patterns. Next section provides a basic theoretical framework that will guide us through the cross-country empirical evidence.
3.1. The price index
where P Tt , P St , and P At are tradables, services, and administered prices, respectively.
where π t = dP t / P t denotes domestic inflation, π Tt = dP Tt / P Tt is the tradables inflation, π St = dP St / P St stands for the services inflation, π At = dP At / P At is the inflation of administered goods and services, and α T = P Tt / P t , α S = P St / P t and α A = P At / P t are the share of each component in the overall price index. Next, we define each component of the inflation rate separately.
3.2. Tradables inflation
where e t is the growth of the nominal exchange rate measured as foreign prices in terms of domestic currency; π Tf is the foreign tradables inflation rate. Henceforth, we assume π Tf = 0 to save notation.
where r t is the real interest rate.
3.3. Services inflation
where ϕ t is the growth rate of the mark-up factor, w t is the growth rate of nominal wages and q St is the growth rate of labor productivity in the service sector. We assume for convenience that nominal wages grow at the same rate in all sectors of the economy.
where η > 0 is a parameter that measures the speed of adjustment of the mark-up with respect to interest rates variation over time.
where ρ is a constant that measures the sensitivity of the growth of nominal wages to expected inflation, ω denotes responsiveness of the rate of change of money wages to the rate of unemployment. Equation ( 8 ) shows that the growth of nominal wages depends directly on the expected inflation rate. Further, as regards wage-setting behavior, the rate of change of nominal wages also relates positively to workers’ bargaining power, which is assumed to depend negatively on the unemployment rate. That is, the lower the unemployment rate, the better the conditions for workers to bargain for higher wages. Hence, we take heed of the institutional framework of the economy that intermediates the conflicting claims over income between workers and capitalists in the wage decision-making process.
where HC denotes the level of human capital, K is the stock of capital, growth accounts for the output growth rate, and Tech is the level of technological content of the economy. Proponents of the endogenous growth theory argue that increasing human capital ( HC ), which can be proxied by years of schooling of the labor force, for example, also raises productivity (Lucas Citation 1988 ); in other words, the higher the share of population with a college degree or above, the higher the level of collective skills and the creation of value by workers. Endogenous growth theory also states that the process of capital deepening creates positive externalities through learning - by - doing, which affects positively the growth of productivity (Romer Citation 1986 ), whereas from a Kaldorian perspective, output growth is one of the main determinants of labor productivity. Kaldor ( Citation 1966 ) highlights the concept of endogenous technological progress driven by demand (this is the widely known Verdoorn’s Law). This law states the statistical relationship between the growth of labor productivity and manufacturing output; empirical evidence for the same relationship between these two variables seems to be very weak for the other sectors of the economy (McCombie and Thirwall Citation 1994 ). Lastly, another major determinant of the growth of labor productivity is the level of innovative activity. Innovation leads to a higher degree of product differentiation and quality and hence increases productivity (León-Ledesma Citation 2002 ).
3.4. Administered prices
where γ is the degree of indexation of the contracts regulating the supply of public goods and services.
3.5. The general model
Figure 2. Stable inflation rate.
Figure 3. Unstable inflationary dynamics.
Additionally, a higher share of the tradable goods sector α T (which can be seen as a proxy for the degree of openness of an economy to foreign trade) associated with a more significant responsiveness of the growth of nominal exchange rate to changes in the nominal interest rate ψ increases price stability; a higher α T ψ enhances the capacity of central banks to control inflation through an inflation targeting regime, for instance. We can also observe that a higher sensitivity of administered prices to expected inflation γ raises the absolute value of β ; however, if γ is either sufficiently high or low it can also destabilize the inflationary dynamics.
3.6. Inflation in developed and undeveloped countries: a static comparative analysis
Figure 4. Static comparative analysis.
Next, we run an empirical model in order to test the statistical significance of the exogenous variables and the degree of indexation presented in our theoretical framework for a sample of developed and undeveloped countries.
4.1. Description of the data
In this study, we seek to empirically analyze the inverse relationship between the level of inflation and the degree of development for a sample of developed and undeveloped countries over the last years. The rationale behind the inverse relationship between inflation and the degree of development states that in a mature economy the degree of inflation persistence and the propagation of shocks are expected to be smaller. More specifically, in the present work we try to identify, within a set of variables most commonly used to explain the stage of economic development of a country, which ones are the most statistically relevant to explain also the inflation differentials between developed and underdeveloped countries.
Following the theoretical model outlined in the previous section, Table 1 below presents the explanatory variables used in our empirical model, as well as the expected sign of the correlation between each explanatory variable and the dependent variable, namely the inflation rate. First in the list is the degree of development, measured by the level of per capita Gross National Income (GNI – constant 2011, in US$).
Table 1. Description of the variables used in the study.
The variable TRADE accounts for the impact of variations in the degree of openness to foreign trade of an economy on domestic prices. Its expected sign is ambiguous. On the one hand, a higher degree of trade openness may induce a fall in prices. As domestic firms compete in foreign markets, they might be forced to reduce the mark-up factor set on prime costs in order to gain market share, thus causing a decrease in the level of domestic prices. On the other hand, the degree of trade openness can also be positively related to the price level. When the supply of domestically produced goods is sufficiently inelastic, a higher degree of openness followed by an increased foreign demand for the country’s exports may lead to soaring prices. For example, in the short- to medium-run, the supply of commodities in undeveloped countries may be inelastic. In these countries, a higher degree of openness caused by rising exports of commodities may lead to a shortage of food and raw materials internally, thereby fomenting an inflationary process. In short, the sign of the partial effect of changes in the degree of openness on inflation ultimately depends on which effect prevails. In cross-country studies, a negative relation emerges between inflation and trade openness. Romer ( Citation 1993 ) presents evidence of negative and significant correlation using data for a cross-section of countries. However, as pointed out by Wynne and Kersting ( Citation 2007 , 9) ‘[w]ith more countries participating in the global economy, there will be increased demand for scarce raw materials, which presumably will be reflected in their price, offsetting the price-level effects of cheaper imports’. In other words, an increased degree of openness might yield unwanted effects in terms of price control.
The high technology exports (XTEC) accounts for the influence of the level of technological content of a country on the inflation rate. An inverse relationship between XTEC and inflation is expected as technological progress and its spillover effects upon other sectors (diffusion) are directly related to the growth of labor productivity, thus reducing unit labor costs and allowing firms to set lower prices. Footnote 4
Growth of Terms of Trade (GTT) represents the price effect of a change in export prices relative to import prices on domestic inflation. Terms of trade are used as a proxy for the real exchange rate since both are strongly correlated. Furthermore, we use the relative prices of exports and imports since it is these relative prices to which exporters and importers respond, thus providing the ‘microfoundations’ on which the model is based. We claim that firms’ export and import decisions are more likely grounded on relative prices of exports and imports. A positive GTT fuels inflation as it raises the price of tradables. Currency devaluation makes both the exports and imports of the home country become more expensive in terms of domestic currency (see Gruen and Dwyer Citation 1995 ). The rationale behind the positive correlation between terms of trade and the price level is that rising prices of tradables following devaluation is passed through into the overall price index. Since the dependent variable is inflation, the growth – instead of levels – of terms of trade performs better as explanatory variable.
The index of human capital per person is associated with the workers’ abilities to produce more efficiently. We expect a negative effect of this measure of the ability of workers upon the inflation rate, through the productivity channel. It is well known in the literature that the technological diffusion process requires a minimum amount of labor force qualification to produce some positive effects on productivity and real income of a country (Woo Citation 2012 ).
Lastly, we account for the intensity of the business cycles (recessions and expansions) and its effects on domestic prices through changes in the dynamics of the labor market. Buoyant demand conditions tighten the labor market and encourage workers to bargain for higher wages, thereby putting an upward pressure on prices. Thus, the yearly change in the unemployment rate exerts a negative expected impact on inflation.
The database consists of a sample of 65 countries, ranging from 2001 to 2011 ( T = 11 years) according to availability of information from World Bank data set, in a context of dwindling economic activity. The complete list of sample countries used in the study is put on the Appendix 2 . At the end we have N = 65 * 11 = 715 complete data points. Footnote 5
4.2. Empirical framework
Broadly speaking, the idea here is to test the empirical relationship between economic development and inflation. To begin with, we assess the partial effect of changes in the stage of economic development of a country, proxied by the level of per capita GNI, on inflation. For methodological purposes, first we regress the inflation rate only against the per capita GNI, and then we include in the baseline equation the inflation rate with a lag as an explanatory variable in order to account for the degree of persistence of inflation. Having done that, we move on to the next step of our empirical model. Since economic development is such a broad concept with multiple determinants, just pointing out that different stages of economic development may give rise to differences in the level of inflation across countries does not help much in terms of policy. This problem raises a couple of questions, such as: Do all the determinants of economic development also have an effect on inflation? If they do, then what are the determinants of economic development? If not all the determinants of economic development also impact on inflation, then what are the most relevant variables that could explain both economic development and inflation? Our theoretical model sheds some light on this issue by suggesting a number of variables that could explain economic development and ultimately inflation. The aim of our empirical work is to verify if the explanatory variables listed in the theoretical model are statistically relevant to explain inflation.
where y is the dependent and X a matrix of independent variables.
Lastly, we extend the model (15) by including an AR(1) coefficient for each individual country to measure the persistence of inflation in each particular country and to investigate the correlation, if there is any, between initial per capita income and the degree of persistence of inflation.
4.3. Results and discussion
Before presenting the results for all specified models (13)–(15), we have carried out the pre-tests for non-stationary panel data along with the semi parametric test for the null of absence of unobserved effects suggested by Wooldridge ( Citation 2002 , 10.4.4). In this case, the test is designed to verify whether there are unobserved effects in the residuals. The statistic of the test is asymptotically distributed as a standard Normal regardless of the distribution of the errors and it also does not rely on homoskedasticity. Not rejecting the null hypothesis favors the use of pooled OLS model (Table 2 ).
Table 2. Results for the null of absence of unobserved individual effects.
The results for the unit root tests in the heterogeneous panels are shown in Table A3 in the Appendix 2 . From those results, we are able to reject the null of unit root in all cases. Important to notice, we apply the unit root test for heterogeneous panels introduced by Im, Pesaran, and Shin ( Citation 2003 ) because its main advantage is that it accommodates heterogeneity across groups such as individual specific effects and different patterns of residual serial correlations. This test produces more reliable inference. As it can be inferred from the results exposed in Table 3 , once we allow for more general version of the relation between inflation and the degree of development, no evidence of individual effects in the residuals was found.
Table 3. Results for the basic model with lagged dependent variable.
Since all variables may be considered stationary and there is no evidence of fixed-effects in these data, for the last two versions of the extended model (14), (15) we adopt a Pooled OLS regression and later the FGLS estimator to account for heteroskedasticity. To get a first approximation, we first estimate the more basic model with and without the lagged dependent variable, to generate information without our selected controls.
From the results shown in Table 3 , three main conclusions can be drawn. First, all coefficients have the expected signs and are statistically significant at conventional levels of probability. Second, there is a negative and statistically significant relation between the degree of development and the inflation rate in the sample of countries. Third, the inclusion of the lagged dependent variable maintains the sign and the significance of parameters, but the absolute magnitude of its coefficient is lower. Additionally, the goodness-of-fit of the model has increased by more than three times when that variable is included.
The results for the most complete version of the model, as stated in Equation ( 15 ), are shown in Table 4 . We used both Pooled OLS and two steps FGLS estimators following Wooldridge ( Citation 2002 ), since the results for the former estimator indicate rejection of the null of absence of heteroskedasticity in the residuals. From Table 4 , when we account for heteroskedasticity with more efficient estimator, we can also infer that lower dispersion for coefficients is found, but their magnitude and signs still remain unaffected, except for human capital, to which no significant influence was found before.
Table 4. Results for extended model.
The first conclusion to be drawn is that the magnitude and sign of per capita income and its influence on inflation rates are similar to the first result presented before. When we analyze the results from the more efficient estimator, we note that only human capital does not exert significant influence on the inflation rates. All estimated coefficients present the theoretically expected signs and are significant at 0.01 level of probability. Additionally, we observe that there is a significant interaction between the level of persistence of inflation and degree of economic development.
Indeed, the results above contrast with those found by Romer ( Citation 1993 ) in a cross-section of countries without controls, in two important aspects. First, a robust negative and significant correlation between inflation and per capita income was found. Second, unlike Romer ( Citation 1993 ) and Temple ( Citation 2002 ), we did not find statistical evidence of a negative impact of trade openness on inflation when explicit controls are considered.
It is widely known that once we add proper controls the previous results may be difficult to remain. In line with Barro ( Citation 1991 ), at first sight the hypothesis that poor countries tend to growth faster than rich countries seems to be inconsistent in a cross-section data analysis for 98 countries. The per capita growth rates have little (and positive ) correlation with the initial level of output per capita. However, when Barro ( Citation 1991 ) added a set of proper controls like human capital and the share of government consumption he finds strong evidence of significant and negative relation between the growth rates of output per capita and the initial level of output per capita. Thus, for the same reason, we suggest that those finds of Romer ( Citation 1993 ) should be viewed with caution (see Temple Citation 2002 for a critical review).
To further explore this result, we estimated the model (15) with all variables applying the panel regression with AR(1) Prais-Winsten correction and panel weighted least squares in which each country has an estimate of the individual degree of persistence of inflation, measured by the individual autoregressive coefficient of lagged inflation rate. The results are plotted in Figure 5 below where the initial income is related to the degree of persistence of inflation in each country. This last result is used at end by correlating the individual autoregressive coefficient with the initial degree of development. The three different correlation coefficient estimates are show in Table 5 , in which a negative and low correlation was detected. The main conclusion is that there is a low but negative association in all correlation sample statistics relating the degree of development and the inflation persistence.
Figure 5. Dispersion between the inflation persistence and the initial per capita income, US$.
Table 5. Correlation coefficient estimates – results.
The explanation for that lies in those circumstances by which this correlation was determined, mainly the degree of technological content of the economy, degree of openness and terms of trade, beyond the state of demand. In spite all these factors are been controlled for, from Figure 5 below there seems to be a regional or institutional component that tied the degree of persistence of inflation with income in a group-level phenomenon, which suggests future research that extends the model to include institutional detail, along the lines pointed by Acemoglu and Robinson ( Citation 2012 ) and IMF (International Monetary Fund) ( Citation 2016 ), may prove illuminating. We speculate that the most probable reason for this low correlation may be the absence of proper controls, like the regional and institutional controls for a grouping effect in the sample countries.
Finally, the Figure 5 above plots the correlation between the initial degree of development and the inflation persistence. Footnote 6
The curve line is a smoothed nonlinear function adjusted to the data, and the straight line is the trend line of the regression, in which the initial level of income plus a constant explain persistence. From the result above, we may conclude that there are sound reasons helping to explain why a number of countries may endure a higher level of inflation conditioned upon its degree of development. These theoretical expected results were partially corroborated by a detailed empirical examination through a cross-section, panel data analysis.
This work studied the relation between economic development and level of inflation and found a statistically significant inverse correlation between them. Our panel comprised data for 65 countries between 2001 and 2011 and revealed that inflation levels are affected by development-related factors. Results indicate that our theoretical model adequately portrayed the problems at hand, whereby expected signs were all vindicated by empirical tests, namely: the persistence of inflation, GTT, degree of openness to trade were positively related to inflation, whereas heightened levels of economic prosperity (per capita income), of the share of high-tech exports and of unemployment growth corresponded to lower inflation rates. The connection between human capital and inflation was not statistically significant, probably due to the former’s long-term nature, falling short of revealing a more clear effect in time range defined by our data sample. Further improvements are required to empirically unearth the impacts of productivity on inflation rates in cross-country data samples.
Moreover, the fact that per capita income maintained some explanatory power over inflation rates suggests that our model did not exhaust the set of development-related forces affecting inflation. As a consequence, it opens up possibilities for further investigations. For instance, there seems to be a regional or institutional component tying the degree of persistence of inflation with per capita income in a group-level phenomenon. We speculate that the most probable reason for this low correlation may be the absence of proper controls, like the regional and institutional controls for a grouping effect in the sample countries. We intend to delve into these matters in subsequent studies.
Furthermore, the paper offers valuable insight regarding the complex nature of the drivers behind inflation in different countries. Its relevance is twofold. First, it addresses a deficiency in the academic literature on inflation, which has strikingly ignored, to the best of our knowledge, the empirical fact that undeveloped countries are subject to higher inflation levels on average than developed economies. This issue is seldom mentioned and, when it is, arguments are superficial and attribute these differentials to circumstantial aspects of monetary policy rigor and institutional detail, such as Central Bank independence or the adoption of some variant of the inflation-targeting regime. Under this hastened approach, inflation is stripped of its long-term forces, which are brought in whenever convenience dictates. This point leads to our second contribution, that is, its policy implications.
Our conclusions question the widely held understanding that inflation control is but a matter of Central Bank’s credibility and willful austerity in daily management of aggregate demand. Our narrative supports the long-standing structuralist views (both Latin American and Anglo-Saxon) that long-term development-related features act upon the level of inflation a country is likely to endure, no matter how determined and stern its central bankers prove to be. This is not to say that a vigilant monetary policy cannot be effective in curtailing inflation; it only means it is likely to leave the latter’s original causes unaffected or, which is worse, reinforce them through adverse – because overlooked – channels. As a result, we claim inflation control should not be construed as the realm of sole monetary policy but a part of a broader development policy, whose primary objective is to enhance a country’s capabilities of catching up with those already developed while disciplining the distribution of income and wealth accrued from the collective effort of production. Not taking heed of these forces is bound to render moot the most sincere determination by policymakers engaged in inflation control.
Lastly, it is worth remarking that our work is but a preliminary investigation on the links between inflation and economic development and, as such, it is certainly not meant to be the final word on this issue. Admittedly, there are multiple areas in which our theoretical and empirical models can be extended, improved or even challenged through the incorporation of additional transmission channels and the employment of different econometric techniques and data sets. Given the complexity of this topic, we decided to leave some important questions for future research, to which we invite the readers to stay tuned.
No potential conflict of interest was reported by the authors.
Source: Authors’ elaboration from the World Bank data set and Barro/Lee Homepage for HC.
Source: Authors’ elaboration.
*** statistically significance at p = 0.01 level.
Notes: (i) *** statistically significance at p = 0.01 level. (ii) To obtain the results for last column we used the estimation in two steps by FGLS (Wooldridge Citation 2002 , 10.4.3 and 10.5.5); (iii) the t -statistic between brackets in case of pooled regression and z-statistic in case of FGLS estimates. We included the time dummies in all regressions.
Notes: (i) *** statistically significance at p = 0.01 level. (ii) For the models (14) and (15) we used the estimation in two steps by FGLS (Wooldridge Citation 2002 , 10.4.3 and 10.5.5); (iii) the t -statistic between brackets in case of pooled regression and z-statistic in case of FGLS estimates. We included the time dummies in all regressions.
We thank the anonymous referee and Professor Ricardo Summa at the Federal University of Rio de Janeiro for valuable suggestions and comments on a draft of this paper. Remaining errors are our own.
1. Two papers back in the late 1950s undertook this task. Wai ( Citation 1959 ) and Bhatia ( Citation 1960 ) also found no clear relationship between economic growth and inflation. Both were also constrained by the idea that development was a synonym with growth, a very common connotation at the time.
2. Underlying our working hypothesis is the assumption that the relation between inflation and the level of development is a group phenomenon, where some common set of forces sustains inflation rates in undeveloped countries above those endured by high-income countries. Countries classified within the same range of development may still display distinct inflation trends, while being bound by a shared structural ‘inflation floor’.
3. The premise behind this assertion is that countries should – and would be able to – achieve such a goal, if they simply follow ‘widely accepted’ central banking good practices. It is yet to be demonstrated that there exists such gravitational force pulling economies onto 1–3% inflation levels.
4. Woo ( Citation 2012 ) and Blanchard and Johnson ( Citation 2013 ) work out one specific channel through which high-tech exports can affect inflation, that is, as the production structure moves toward more sophisticated and technological advanced sectors of the economy allowing a high growth rate of demand and low unemployment be sustained in an environment of stable and low inflation, being China a clear-cut historical experience of an economy switching from a commodity export based to the largest exporter of high-technology products in the world. This result concurs with the general claim, made by Rogoff ( Citation 2003 ), that increases in productivity have been a major force behind global disinflation from the 1990s onward.
5. All computations and plots were done in R (R Core Team Citation 2015 ).
6. One topic only superficially touched upon in this paper refers to persistence of inflation. Often associated with lack of government willingness to cut demand in poorly managed undeveloped economies, this phenomenon is no stranger to developed economies, having been fairly well documented in time series data for OECD countries in the postwar era. In fact, the European Central Bank has setup its own institutional branch to oversee the phenomenon: the Eurosystem Inflation Persistence Network (see Marques Citation 2004 ; O’Reilly and Whelan Citation 2004 ).
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where ν T = Q Tt / Q , ν S = Q St / Q and ν SM = Q SMt / Q . In other words, the parameter ν stands for the share of labor productivity of each sector in the total labor productivity. In equilibrium, the values of ν T , ν S and ν SM must be constant otherwise there is a growing sectoral imbalance in the economy. More formally, if the shares ν are constant, then the labor productivity of all sectors are growing at the same rate as the total labor productivity of the economy, that is q t = q Tt = q St = q SMt .
Table A1 below describes the sample countries used in the study. Tables A2 and A3 present, respectively, the summary statistics of variables and the results for unit root tests on variables.
Sample of countries.
Source: Authors’ elaboration from the World Bank and Barro/Lee homepage for HC.
Results for the null of unit root test in all variables.
Notes: (i) *** statistically significance at p = 0.01 level; (ii) the best lag length was obtained using the AIC criterion and fixing the p max = 3 following the suggestion of Im et. al. (2003).
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A Study on Inflation
21 Pages Posted: 14 Apr 2021
Date Written: March 31, 2021
The report entitled –“A Study on Inflation” elucidates inflation (or less frequently, price inflation) which is a general rise in the price level in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money– a loss of real value in the medium of exchange and unit of account within the economy. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. Economists believe that very high rates of inflation and hyperinflation are harmful, and are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. Inflation affects economies in various positive and negative ways. The negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include reducing unemployment due to nominal wage rigidity, allowing the central bank greater freedom in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation. Today, most economists favor a low and steady rate of inflation.Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
Keywords: devaluation, Consumer Price Index (CPI), Keynesians, monetarists
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Inflation in the us economy.
Inflation is the general rate in which the prices of goods and services go up and the purchasing power of a given currency goes down. It is usually expressed as a percentage per year. To explain inflation further, an example is given. If an item costs $2.00 and the annual inflation rate is 4%, then the item will be $2.08 after the inflation. The same money buys less percentage of the good or service than it did before. When the level of inflation is too high, the purchasing power of the currency drops (Cumes 14). The rate of inflation in a country is brought about by various causes. The causes are as follows. Demand-pull inflation is caused by the rise in demand for goods and services in a country. This causes the prices to go up ending in inflation. The other type of inflation is the cost-push inflation. This is brought about by the cost of production in the companies going up. The prices of the goods are set high by the companies in a bid to maintain their profits. The other cause of inflation is the monetary inflation. This is caused by the excessive supply of money in the economy. This leads to the currency dropping in value. Prices of commodities expressed in terms of the dollar go up.
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Inflation in the United States of America dates back in 1872 from the work of Pearson and Warren. The inflation by then was brought about by the increased demand where the economy was expected to provide more than it could supply. This led to the prices shooting to cater for the mechanization and hiring of more workers to take care of the production and satisfy the large market. The inflation could also have been caused by the act of the companies setting their own high prices for the goods. Similar companies were forced to do the same to catch up with their competitors in the market.
Government deficits in the budget also caused inflation. This was due to the urge to raise more money to cater for the deficit. This had an effect on the price of goods. The prices went up, and subsequently, inflation of goods in the economy emerged (“The History of Inflation in America since 1872”). The current annual inflation rate in the United States of America is 2.4% for the year ended in March 2017. Such a rate is beneficial to the country’s economy and is likely to bring more positive outcomes than the negative outcomes. The country has recorded an average level of inflation of 2.5% per year. The level of inflation has increased in the recent years as illustrated below.
The increase has been due to the increased demand for the goods by the local and international markets and the limited supply of the goods. This has caused the prices to go up leading to the increase in the rate of inflation (“Historic Inflation-United States”).
Inflation has both positive and negative implications to the economy of a country. The positive effects are realized when the rate of inflation in a country is maintained at a low percentage. These include an increase in the employment opportunities, and the presence of more money to buy commodities. Low rates of inflation are an indicator that the economy is progressing in the right direction. There is a constant availability of job opportunities in both upcoming and already established companies in a country. There’s also a constant supply of cash in the economy. Purchases are made efficiently and at the right prices. This makes the currency retain its value.
The negative effects of inflation come up when a country has excessive inflation rates. These are rising cost of living, increase in the cost of production, and erosion of the purchasing power. With the rise in the rate of inflation, prices of goods and services go up, and since the flow of the currency is constant, people strain to get the commodities. The rise in the prices of commodities is due to the rise in the cost of raw material and other factors involved in the production. This increases the cost of production of goods. The purchasing power of the currency falls, and the currency loses value, this is due to the high rates of inflation (“What are the effects of Inflation on the Economy?”).
The following solutions have been offered to reduce the rates of inflation: monetary policy, change in taxation levels, and wage control. Monetary policy includes the rising of the interest levels to encourage saving, discourage spending, and discourage borrowing to regulate the inflation. Increasing the levels of taxation on goods and decreasing the government spending reduces the rate of inflation. Rapid increase in the wages of laborers increase the prices of goods leading to inflation. Regulation of the wages reduces inflation (“The Inflation Solution”).
Demand-pull and cost-push inflation has been experienced in the United States of America. Demand-pull inflation is the type of inflation where the increase in the aggregate demand for goods in the sectors of the US economy exceeds the supply by the economy. The companies are forced to look for other employees who will work extra top satisfy the market requirements. The wages increase, leading to an increase in the prices of goods. This increases the level of inflation in the country. The increase in the government purchase can lead to the increase in the aggregate demand and subsequent rise in the rates of inflation.
Cost-push inflation is a type of inflation where there is a reduced supply of goods as a result of the costs involved in the production. Prices have to up due to the high costs of production in the economy. The companies raise the prices of goods in the United States of America to maintain their profit margins. For example, if a certain company in the USA increase the number of workers, the additional workers have to be paid. The company may increase the prices of commodities passing the same implication to the consumer. This is done to ensure that the company remains profitable (Keel 17).
- Cumes, J W. C. Inflation! Elsevier Science, 2014.
- “Historic Inflation-United States.” Inflation – Up to Date Info on Current and Historic Inflation by Country. www.inflation.eu. Accessed May 03, 2017.
- Keel, Laronda. Inflation. Orange Apple, 2012.
- Kennon, Joshua. “What are the effects of Inflation on the Economy?” The Balance, 2016. www.thebalance.com. Accessed May 3, 2017.
- Short, Doug. “The History of Inflation in America since 1872.” Business Insider, 2015. www.businessinsider.com. Accessed May 3, 2017.
- “The Inflation Solution.” The Economist, 2010, www.economist.com. Accessed May 3, 2017.
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Example Of Research Paper On Inflation
Type of paper: Research Paper
Topic: Government , Economics , Money , Inflation , Countries , Banking , Economy , World
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World economy is a complex unity of all local economies represented in the world. Due to the continuous processes of globalization and integration, whatever changes take place in one country, they are easily shifted into another area along with all related effects. That could be even compared to “the domino effect”. And it would be a very positive aspect if not for all the bugs and issues which evolve each day on every market, either local or global, influencing the overall situation in one country or the world economy as a whole. Quite many economic “viruses” can be recalled now as the ones most threatening the security of the modern economic system. In fact there is no country in the world that is not involved in the global policies aimed to eliminate current economic risks. Due to the World Economic Forum Global Risks 2013 Report, the threats are the unmanageable inflation and deflation, prolonged infrastructure neglect, unforeseen negative consequences of regulation, severe income disparity, chronic labor market and fiscal imbalances, extreme volatility in energy and agriculture prices, recurring liquidity crises and others. The question stands only in how well one can cope with the problem; how sufficient a country is in order to eliminate all the negative outcomes; is the issue manageable within a country’s borders or it brings a threat of infecting the economic group to which it belongs. The global economic system consists of those two major groups of developed and developing countries. In a meanwhile, developed countries form its own high-privilege groups in order to protect themselves from the foregoing issues, which developing countries strive to fight. It would be worth mentioning the example of the European Union with its European Free Trade Association as well as the group of G7 countries (US, UK, France, Germany, Italy, Canada and Japan). Nevertheless, the fact cannot be ignored that the emerging countries also try to form its own unions and have its own agreements so they are not that much vulnerable to common economic issues. Those are the E7 countries, as outlined by PriceWaterhouseCoopers LLC (Hamilton, 2011), China, India, Brazil, Russia, Indonesia, Mexico and Turkey. They are promised to gain more economic power by the time the half of the 21st century passes by. Whatever policies the “stronger” countries pass “Europe is imploding, the UK is contracting, the US is stagnating and, while Asia is cooling, it at least has the policy tools to be able to rebound” (Lyons, 2012). The pace of global growth has slowed down in the past couple of years and all thankfully to the lack of immunity against those previously mentioned global risks being spread by the controversial processes of globalization. Notwithstanding, all the efforts we can see countries doing to protect themselves, uniting and implementing needed policies, there is still one issue that we are going to discuss among the main threats of the global economy. The inflation, as was mentioned above, grabs its position closer to the TOP of the list of all the issues. Along with the increasing debt levels and unsustainable economies, the inflation brings high level of risk into the policies of some countries, which try to fight the existing fiscal constraints. What is the actual origin of the issue? What harm can inflation do to the specific economies, and as a result, to the global economy? What other issues combine with and feed inflation, so that the government needs to find cure for both? These and many other questions need to be discussed before we can tell for sure how influential this problem is for the modern world economic systems. Inflation is generally known as the annualized percentage of rise in the price level of goods and services. Most often to be able to get a grip of the price level experts use the consumer price index, sometimes also the personal consumption expenditure deflator and the GDP deflator. Obvious is the fact that it is essential to concentrate more on core inflation, which excludes the influence of volatile prices for food and energy, rather than overall inflation. The study of Robert James Ball “Inflation and the Theory of Money” (2009) also offers a quote defining the whole inflation process as “too much money chasing too few goods”. That supposably implies the existence of specific relation between the money, the supply of goods and their prices, which is in fact quite easy to dispute considering the fact that this statement is not quite neutral in relation to other economic definitions. In the situation of price level rising each unit of currency can buy less goods and services. Based on this presumption it can be judged that inflation is also a situation of reduction of purchasing power of a specific currency per its every unit. For the economy it means that money lose their real value in terms of exchange and account. What is the reason for inflation to occur? Those can be quite a few, though at first we need to go over the types of inflation currently present in some countries. Depending on the coverage, inflation can be comprehensive or economy wide, covering all inner markets, or sporadic, relating to specific fields of economy. For example, price raise in food market due to the bad climate conditions and poor crop. Divided by the time condition, there is war-time inflation, caused by the hige demand for essential commodities, post-war inflation, caused by the soaring prices while the governmental policies are in a “frozen” state and peace-time inflation, when government expenditures for the development projects are increasing. More often inflation is divided into two simple types – open and suppressed inflation. The first one occurs in free market economy, where prices are set by businesses freely and there is minimum regulation. Its opposite side, the suppressed inflation, occurs when there are many price restrictions set, which consequently result in evolving black markets, bribes, artificial scarcity, etc. The most widespread differentiation of the inflation term is used while judging by the rate of increase in prices. Therefore, the annual rise of prices not more than by 3% can be called the creeping inflation (also mild or low). If the rate of approximately 3% annual price raise holds for a longer period than just a year, then the experts call this inflation chronic or secular. This type of inflation can be also periodical, taking breaks and then repeating again in its own cycle. When the inflation rate goes over 3% but does not reach 10% per year this type is called walking inflation. This is the one which should be a signal for the economy to look deeply into the nature of price raise, as it can easily turn to more damageable running inflation. The last one is said to occur with the rapid 10% to 20% price raise annually. This one, if not being cured, grows into galloping inflation with over 20% but less than 1000% price increase annually. And the last and the most destructive one is hyperinflation with over 1000% price increase annually. The hyperinflation is the situation of never ever seen price raise, when paper money simply lose any value and people start doing trade transactions in gold or silver. One bright example of this paradox is the hyperinflation in Weimar Republic Germany, 1923. People even started to use old barter commerce system to do some transactions. Without doubt, the most unique examples are the Hungarian pengo fall in 1946 and Zimbabwean dollar fall in 2008 with more than 50 million percent annual inflation rate. As for the primary causes of inflation, there are two theories fighting to be the main explanation of its nature. The monetarism views support the idea of the raise in money supply to be the reason for inflation. On the contrary, the Keynesian views are rather more supportive of the fact that the economy disorder is the one that is being reflected in changing prices. Hence, they argue these changes cannot take place only due to the money supply raise. With all the causes of the issue still being debated, its consequences are clear - the inflationary state is highly unacceptable as leads to the direct economic downfall. That is where the Central Banks around the world start taking measures in order to lower or at least stabilize the inflation rates in their countries. The Central Banks are usually the main authorities regulating the money supply in the countries. Therefore, they face a hard task of mediators between the government and businesses while tolerating necessary regulations. They all strive for price stability in order to restrain inflation rates from rapid growth. For instance, on the official website of the Bank of England it is outlined “The Bank sets interest rates to keep inflation low to preserve the value of your money” (The Bank of England, 2013). The research conducted by the team of economists from the Federal Reserve Bank of San Francisco collects also the main goal of the US Federal System monetary policy as to promote stable prices. It also outlines the main purpose of the Central Bank of Chile as to keep the inflation rate low and stable, centered on 3%. Other Central Bank that also puts the mark “high priority” on price stabilization is the Bank of Canada with the goal “to contribute to rising living standards for all Canadians through low and stable inflation” (Federal Reserve Bank of San Francisco, 2006). Also according to this research, the European Central Bank statement claims to set the maintaining of the price stability as “the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the treaty establishing the European Community, Article 105 (1)” (Federal Reserve Bank of San Francisco, 2006). Holding the evidence of all these governmental institutions fighting inflation, putting all efforts into lowering price level, experts have to be extra careful considering the fact when exactly the inflationary situation occurs. What is that specific estimated general price level and on which basis should we make decision that this specific price level is the critical one? This is usually defined for each country separately, even if it is a part of some association (for example, the European Union). While being a part of a greater unity, each country still has its own tasks to work on. Apart from understanding the whole process of inflation, we also should define concrete positive and negative effects that are brought along. No doubt, that the negative sides take over the positive ones, but there are some points to add to the “white list”. First of all, inflation, if steady and balancing between 1% and 3%, might be a good reason for the business profits and revenues boost and, simultaneously, the increase in worker payments. As the businesses let themselves raise the prices and get more money, that will lead to the their psychological confidence and bring eagerness to invest and raise their productivity. The government will also be able to find itself in a payoff due to the “fiscal drag effects” caused in many cases by the inflationary processes. In short, the reason for that is the increase in tax. If we take some indirect taxes, like VAT, for instance, the part that is withdrawn as tax is getting bigger with a raise of the price, so the tax revenues flowing to the treasury are also increasing. Other point adding to the positive performance inflation may cause is the possibility of the public sector debts reduction. Inflation may help the borrowers to bring down a bit the real value of their loans and at the same time it will be good for the government as the public debt level will increase. However, all of the outlined consequences of inflation are good as long as they are backed up by its stable and low percentage. When inflation rates are getting out of the recommended boundaries, inflation is causing too much trouble. Remarkably, this damage is not only the headache of the government or the business sector. The society also finds its own inflation costs. According to the survey conducted by the Yale economist Robert Shiller (Shiller, 1996), the general public finds the following inconveniences caused by the unmanaged inflation: political instability, loss of morale and the considerable damage to the national prestige. In many cases, as has been noted by Shiller, the news about increasing inflation rates caused failures in the elections for some presidents and decrease in their ratings among the electorate. The public polls also acknowledge the fact of strong dissatisfaction the public holds against inflation and regards it as the most important national problem once it is announced (Shiller, 1996). All in all, those would be called the social costs of inflation. What about the economic costs of inflation? Those actually evolve when the inflation percentage is too high, for instance, when the running or galloping inflation is present in the economy. As if it is stable and low we might rather face foregoing positive effects. Though when the prices go out of control the damage can be as big as irreversible. Different groups can be affected quite harshly. For example, the households which have savings of their own lose a considerable amount of money taking into the account the loss in the real money value. Another risk they might face can occur if their interest rates are lower than actual level of inflation, as in this case, they can get the negative real interest rate. Consequently, it is safe to assume that whatever interest rates banks offer to the potential savers in general, that must be the anticipated level of inflation for that specific period of time. In a meanwhile the borrowers actually happen to be in a better position. They may find themselves more secure at the expense of the last mentioned savers as the real value of their loans slightly erodes. Another thing worth to mention is the so called “wage-price spiral”, when the increase in prices pushes workers into demanding higher wages for themselves, so that they can maintain their real living standards (Riley, 2012). However, the wage question is not the only one problem that arises in terms of labor market. Its most numerous part is represented by those workers whose jobs are low paid. They are as well unprotected by any labor unions, hence, are the most vulnerable. People simply have no ways of asking for higher wages and that is not just an economic issue, it aims to be the social issue as well. Moreover, the high inflation rates are also a cause for higher unemployment. With labor force being one of the key concepts where businesses and the economy stand on, issues on the labor market sure result in serious economic downfall. The lack of professionals and quality remuneration for their work may lead to such damage as direct decrease of GDP. This surely affects the trade performance of the country. Obviously, this situation is not a good sign for the economy and is more of a red light for both the government and the business sector to rethink its policies and seek the ways of collaboration. The snowball of issues caused by the unmanageable inflation also grows bigger when the processes of business planning are being disrupted. “Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned investment spending” (Riley, 2012). The overall conclusion we can make while talking about the effects of the inflation is that it is a matter of seldom occurrence that the rates of inflation are constantly low and stable, well maintained and non-risky. Hence, negative consequences ought to be expected more often. However, the most damage comes from the unanticipated inflation. It can cause much uncertainty for businesses and people as its rates cannot be correctly predicted for the nearest future. Usually, it is claimed to be the government’s fault when the inflation forecasts come out to be faulty. This might lead to the income losses and wealth redistribution from one social group to another. People can be easily confused while counting on the nominal value of their income, when in fact part of it is consumed solely by inflation. So despite the fact that they expect some certain percentage of general raise in their earnings, it can be covered up solely or partly by the percentage of inflation raise. This way people will not get any payoff, but the illusion of it. It is much safer to have an anticipated inflation, which at least gives some possibilities to hedge against currency fluctuations. This goes in regard not only with businesses, it gives some more time for labor unions to bid for higher wages for the union members, thus, may prevent the labor market from rocketing unemployment statistics. Households with savings also get more time and opportunities to switch to different interest rate plans, higher than the predicted inflation rates. Consequently, they do not lose their money, but at least stay on the same level. We are not even talking about earning some add-on to their savings, which is of course their primary aim. Simultaneously lenders can protect themselves by taking time to adjust their interest rates. So both sides can stay on track during the hard times of inflation raise. Talking about businesses as the major group dealing with inflation, they can also win time to adjust prices, collect some resources before the inflation boost. They simply use the technique of “forward business”, when some transactions are done according to the forecasts.
Ball, R. J. (2009) Inflation and the Theory of Money. Chicago: Aldine Pub. Co. Federal Reserve Bank of San Francisco (2006) How does inflation affect economies? Retreived from: http://www.frbsf.org/education/publications/doctor-econ/2006/march/inflation Hamilton, S. (2011) G-7 Will Be Overtaken by Emerging Economies by 2032, PriceWaterhouse Says. Retrieved from: http://www.bloomberg.com/news/2011-01-07/g-7-economy-will-be-overtaken-by-emerging-markets-in-two-decades-pwc-says.html Lyons, G. (2012) World economy: still divided after all these years. Retrieved from: http://www.nationmultimedia.com/opinion/World-economy-still-divided-after-all-these-years-30190192.html Riley, G. (2012) Inflation Consequences. Retrieved from: http://www.tutor2u.net/economics/revision-notes/a2-macro-consequences-of-inflation.html Shiller, R. (1996) Why Do People Dislike Inflation? [PDF document]. Retrieved from the National Bureau of Economic Research Web site: http://www.nber.org/papers/w5539 The Bank of England Official Website (2013) Retrieved from: http://www.bankofengland.co.uk/Pages/home.aspx World Economic Forum Global Risks Report (2013) [PDF document]. Retrieved from the World Economic Forum Web site: http://www.weforum.org/reports/global-risks-2013-eighth-edition-japanese-0
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Research Paper - Inflation Rate in the Philippines
This research paper tackles the factors that affects the sudden rise of the inflation rate in the Philippines.
Mc Reynald II S Banderlipe
This is a paper written for the course ACT514M (Macroeconomic Theory) taken during Term 1, SY 2006-2007. It highlights the importance and dynamics of exchange rates and its role in macroeconomic policy formulation towards sustaining economic growth. Please do not cite. Thank you.
YOUNG, C. E. F. Economic Adjustment Policies and the Environment: a case study of Brazil. Doctor of Philosophy Thesis, Department of Economics, University Collegue London,1996.
Carlos Eduardo Frickmann Young
Adjustment programmes in developing countries have been the subject of intense debate since the debt crisis in the early 1980s. Consideration of environmental consequences of adjustment policies has added a new dimension to the discussion. This thesis focuses on this issue, examining the links between adjustment policies and the use of natural resources. The first part of the thesis comprises a review of the international literature and the development of a macroeconomic model relating effective demand and the use of natural resources. The second part is dedicated to the analysis of environmental consequences of adjustment policies in Brazil. It starts with a brief review of macroeconomic policy in Brazil since the oil crisis in the mid-1970s. Then three environmental problems are looked at: deforestation in the Amazon, mineral depletion and industrial water and air pollution. In the three cases there are important links between adjustment policies and the worsening of environmental conditions. The thesis suggests two broad conclusions. First, while the final outcome of the adjustment policies may be positive or negative, a failure to integrate macroeconomic models with sustainability concerns has meant that existing 'models' of adjustment have not been able to identify the potential inconsistency between the requirements of macroeconomic reform and resource conservation. From the adjustment country perspective, consumption of natural capital is a simple and effective response to the requirements of short term improvement in the economic performance. The second conclusion is that adjustment programmes should be designed so that short-term disruption is at least partly offset by mitigating environmental policies.
It cannot be said that economic problems are a new phenomenon. Instances of economic dysfunction have been variously observed the world over, evident in such incidences as economic depressions, debt crises, inflation problems, prevailing unemployment, financial instability, and unfavourable internal economic fluctuations. Domestic economic imbalances have resulted in the prominence of International Financial Institutions (IFI’s) – the IMF and the World Bank and their policy prescriptions (and finance) as an external solution to an internal problem. However these recommendations come as conditions attached to a World Bank/IMF backed financial assistance as a somewhat non-mutually exclusive deal. It is these conditions that make a Structural Adjustment Program (SAP), as argued by these bodies, a desideratum in a functionless economy. Implemented without an associated pay-package (as was the case with Nigeria, in what was described as a homegrown programme produced by Nigerians for Nigerians) nonetheless, a SAP still remains, to all intents and purposes, a Bretton woods invention and one in which this paper is centered on. The paper therefore elucidates the Nigeria’s SAP as well as renders a critical probe into the concepts of privatization, deregulation and liberalization as part of the adjustment programme in the economy.
ABSTRACT The objective of this study is to highlight those factors that cause inflation in Nigeria economy in Uvwie Local Government Area of Delta State. The study is descriptive in nature as such. Descriptive survey design was adopted. Three hypotheses was stated in this study, and tested with self formulated questionnaire distributed to respondents in Uvwie Local Government Area. The study revealed that government policies contributes to inflation, also excess demand and shortage in supply of commodities leads to increase in price which is called "inflation". The study also showed that Nigeria
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Fed can't tame inflation without 'significantly' more hikes that will cause a recession, paper says
The Federal Reserve is unlikely to be able to bring down inflation without having to raise interest rates considerably higher, causing a recession, according to a research paper released Friday.
Former Fed Governor Frederic Mishkin is among the authors of the white paper that examines the history of central bank efforts to create disinflation.
Despite the sentiments of many current Fed officials that they can manage a "soft landing" while tackling high prices, the paper says that is unlikely to be the case.
"We find no instance in which a central-[bank]induced disinflation occurred without a recession," said the paper, co-authored by economists Stephen Cecchetti, Michael Feroli, Peter Hooper and Kermit Schoenholtz.
The paper was presented Friday morning during a monetary policy forum presented by the University of Chicago Booth School of Business.
The Fed has implemented a series of interest rate hikes in an effort to tame inflation that had been at its highest level in some 41 years. Markets widely expect a few more hikes before the Fed can pause to assess the impact the tighter policy is having on the economy.
However, the paper suggests that there's probably a ways to go.
"Simulations of our baseline model suggest that the Fed will need to tighten policy significantly further to achieve its inflation objective by the end of 2025," the researchers said.
"Even assuming stable inflation expectations, our analysis casts doubt on the ability of the Fed to engineer a soft landing in which inflation returns to the 2 percent target by the end of 2025 without a mild recession," they added.
The paper, however, rejects the idea of raising the 2% inflation standard. In addition, the researchers say the central bank should abandon its new policy framework adopted in September 2020. That change implemented " average inflation targeting ," allowing inflation to run hotter than normal in the interest of a more inclusive employment recovery.
The researchers say the Fed should go back to its preemptive mode where it started raising rates when unemployment fell sharply.
Fed Governor Philip Jefferson released a reply to the report, saying the current situation differs from previous inflation episodes. He noted that this Fed has more credibility as an inflation-fighter than some of its predecessors.
"Unlike in the late 1960s and 1970s, the Federal Reserve is addressing the outbreak in inflation promptly and forcefully to maintain that credibility and to preserve the 'well anchored' property of long-term inflation expectations," Jefferson said.
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Immigrants contribute a large portion of the growth in the U.S. population and labor force. However, immigration flows into the United States slowed significantly following immigration policy changes from 2017 to 2020 and the onset of the COVID-19 pandemic. Analysis of state-level data shows that this migration slowdown tightened local labor markets modestly, raising the ratio of job vacancies to unemployed workers 5.5 percentage points between 2017 and 2021. More recent data show immigration has rebounded strongly, helping to close the shortfall in foreign-born labor and ease tight labor markets.
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Posted February 1, 2023 Mauricio Ulate, Jose P. Vasquez, and Roman D. Zarate
We examine the labor market consequences of recent global supply chain disruptions induced by COVID-19. Specifically, we consider a temporary increase in international trade costs similar to the one observed during the pandemic and analyze its effects on labor market outcomes using a quantitative trade model with downward nominal wage rigidities. Even omitting any health related impacts of the pandemic, the increase in trade costs leads to a temporary but prolonged decline in U.S. labor force participation. However, there is a temporary increase in manufacturing employment as the United States is a net importer of manufactured goods, which become costlier to obtain from abroad. By contrast, service and agricultural employment experience temporary declines. Nominal frictions lead to temporary unemployment when the shock dissipates, but this depends on the degree of monetary accommodation. Overall, the shock results in a 0.14% welfare loss for the United States. The impact on labor force participation and welfare across countries varies depending on the initial degree of openness and sectoral deficits.
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Monetary Policy and Inflation Targeting Research Paper
View sample economics research paper on monetary policy and inflation targeting. Browse economics research paper topics for more inspiration. If you need a thorough research paper written according to all the academic standards, you can always turn to our experienced writers for help. This is how your paper can get an A! Feel free to contact our writing service for professional assistance. We offer high-quality assignments for reasonable rates.
Inflation targeting (IT) is a framework for the conduct of monetary policy, under which the monetary authority announces a medium- or long-run inflation target and then uses all available information to set its policy instrument, the short-term nominal interest rate, so that this target is met. Short-lived deviations from the inflationary target may be acceptable, especially when there may be a short-run trade-off between meeting the target and another welfare consideration, for example, the output gap—the difference between actual and potential output. Hence, although the central bank commits to meeting a certain inflationary target, in practice, IT takes a less rigid form, with the central bank exercising some discretion over the path of actual inflation toward its target. Recently, dozens of central banks around the world have introduced IT as their operational paradigm. Numerous studies indicate that this policy has been successful in achieving macroeconomic stability at no longrun cost in terms of lower real activity. Many central banks that have not explicitly subscribed to IT have been shown to follow it implicitly.
IT provides a way for the central bank to communicate its intentions to the public in a clear, unequivocal manner, making the conduct of monetary policy more transparent and predictable. Transparency allows the public to hold the central bank accountable for its policy actions. In fact, in some countries, inflation-targeting central banks are subject to intense public scrutiny from the legislative bodies. Predictability of monetary policy allows the central bank to manage public inflationary expectations and better anchor them around the inflationary target; this allows the central bank to achieve macroeconomic stability more effectively.
Alan Greenspan (2004) has famously posited that “the success of monetary policy depends importantly on the quality of forecasts” (p. 39). In practice, monetary policy affects macroeconomic activity with a lag, hence forming accurate forecasts of the future macroeconomic activity is of paramount importance. Several IT central banks are reforming their communications procedures to make their macroeconomic forecasts, as well as projections of the nominal interest rate path to meet their stated objectives, publicly available.
Although, historically, central banks have paid close attention to a large number of macroeconomic variables, there are several reasons for the central bank to focus on only one variable as its target and to make inflation that variable. The central bank generally has only one independent instrument: the short-term nominal interest rate. With this single instrument, the Tinbergen principle states that they can achieve their target for only a single variable. Even though they may rightly care about many macroeconomic variables, they would need new tools to move each one independently. Furthermore, theoretical literature focusing on the role of forward-looking (rational) inflationary expectations formed by the public has shown that central banks that take a particularly tough stance against inflation may generate better macroeconomic performance in the long run (Rogoff, 1985). Inflationary conservatism on behalf of the central bank moderates inflationary expectations and brings about full employment at a lower rate of inflation.
Beyond its theoretical advantages, IT succeeds in practice with lower, more stable inflation and more stable real activity. As more countries adopt the IT framework, the evidence in its support grows. After New Zealand in 1990, a cascade of developed and developing countries followed, including relatively large economies, such as Canada and Brazil, and relatively small ones, such as the Czech Republic and Israel. Although the largest central banks, the European Central Bank (ECB) and the U.S. Federal Reserve, have yet to adopt IT explicitly, in practice, their monetary policy conduct seems to match the IT framework quite closely, with Ben Bernanke, the Chairman of the Federal Reserve, known as an early vocal proponent of explicit IT. Its growing popularity clearly signals the merits of adopting IT as the paradigm for the conduct of monetary policy.
This research paper’s assessment of modern IT first traces its historical roots, exploring both the antecedent monetary frameworks and the developments in economic theory that motivated its present-day form. We then discuss how IT is implemented in practice and the preliminary empirical evidence from the countries that have adopted it. To conclude, we offer suggestions on how the IT consensus might grow and its prospects as a unifying framework for monetary policy.
In 1931, faced with the global depression and speculative attacks on its currency’s gold peg, the Swedish Riksbank began a 6-year experiment with price level targeting (PLT), the first and only of its kind. Just as the gold standard was renounced, the bank promised price stabilization “using all means available.” Like modern IT, PLT sought to commit monetary policy to a single nominal goal. The Riksbank was a likely pioneer, given the country’s economics tradition. As early as 1898, Knut Wicksell, a Swedish economist, discussing the role of the monetary instrument, recommended that the discount rate should move with the price level to dampen its volatility. When its PLT policy was first formulated, the Riksbank was given instrument independence—that is, it could use interest rates any way it saw fit to meet the price level target set by the government.
The price-targeting regime was, however, conceived in a very different context than that faced by the modern IT adopters. In the depressed economic conditions of the 1930s, deflation was a serious risk, and even though many feared inflation after Sweden eschewed the gold standard, adhering to the price level target was also meant to fight deflation that crippled the rest of the world. Indeed, from 1928 to 1932, Swedish prices declined steadily in line with the rest of the world but then rose slowly for the rest of the decade, and though unemployment peaked in 1933, output stayed comparatively strong through the 1930s.
As a proto-targeting regime, the Swedish experiment differed in several ways from modern IT. By committing to hold a specific price level, excess inflation has to be compensated with periods of deflation. In contrast, modern IT does not compensate for inflationary buildup in prices, as long as the rate of inflation returns to the target. The Swedish experiment was initially meant to be only a temporary break from the gold standard. They announced the policy with the caveat that it was a temporary measure, but without a strict ending date. Modern inflationary targeting, on the other hand, can be successful only in the long term, because much of its performance depends on how well the central bank can build credibility and manage the public’s inflationary expectations. To further muddle policy design, the parliament gave the Riksbank its targeting mandate but did not communicate a quantitative target, nor even a price measure (i.e., CPI, wholesale prices, etc.). And while an IT central bank today uses forecasts to communicate its intentions, the Riksbank never published these. The Riksbank’s PLT experiment ended in 1937 when monetary and fiscal policies were reorganized along Keynesian lines to pursue aggregate demand stabilization.
Keynesian thinking dominated policy right through the 1960s, and policy prioritized full employment above price stability. Fitting its diminished importance globally, monetary policy was squeezed into a tight framework after World War II. World prices were anchored to the dollar, which hypothetically was convertible to gold. Central banks still worried about inflation but believed that it could be easily traded off against unemployment in a fashion that did not change over time. A coordinated action of taxing, spending, and discount rate manipulation would pinpoint a position on the so-called Phillips curve, an empirical regularity characterizing the trade-off between inflation and unemployment that policy makers felt could be exploited to match social preferences with respect to these two variables.
The major question became gauging what combination of evils, unemployment versus inflation, would be most socially tolerable. Not surprisingly, the generation that still remembered the Great Depression was more sensitive to unemployment. The popular press was sure of the economists’ prowess, proclaiming in a 1965 Time cover story that successful policy could coax an economy to full employment. The story was titled “We Are All Keynesians Now,” a quote from Milton Friedman1, but it never mentioned policy’s role in guiding inflationary expectations. In the 1950s and 1960s, macroeconomists rarely objected to linking unemployment and inflation with some linear relation and estimating the equation’s coefficients. This led to a natural policy prescription that anytime lower unemployment is desired, inflation should be allowed to increase. The working assumption was that inflation would move along a static Phillips curve, given the rate of unemployment.
An undercurrent of economists in the 1960s and a deluge in the 1970s called to question the status quo that had developed up until then. Accelerating inflation in the United States spread across the world, and the economics profession began to question whether these reduced-form equations really were as time invariant as Keynesians claimed. They tried to ground macroeconomic relationships in models of rational individuals and found Keynesian economics critically incomplete and misleading. The result was a Phillips curve incorporating inflationary expectations that became central in explaining the dynamic macroeconomic evolution.
In his celebrated presidential address to the American Economic Association, Friedman (1968) suggested that a monetary policy that actively tries to promote macroeconomic stability may actually disrupt it because of the poor quality of information available to policy makers. He suggested targeting monetary aggregates (by keeping money supply growth constant) to promote long-term stability. Friedman’s speech almost perfectly coincided with the breakdown of the Bretton-Woods system in the early 1970s, in whose wake central banks were forced to design new operational paradigms for the conduct of monetary policy. This sort of policy is an “intermediate target” because money supply is not a welfare criterion in itself but is a major determinant of inflation.
Money targeting had to be abandoned relatively quickly due to the unstable relationship between monetary and other macroeconomic aggregates. There is widespread consensus that the Federal Reserve pursued monetary targets only between 1979 and 1982. Instead, central banks have started searching for alternative frameworks for the conduct of monetary policy, and toward the 1990s, a number of central banks were poised to start IT.2 Before we document the adoption of IT by central banks around the world, we will lay out a simplified version of the theoretical framework that is frequently used for analyzing the design of an IT regime.
Implementing Inflation Targeting: Theory
A large body of recent theoretical literature has been dedicated to the study of monetary policy. Richard Clarida, Jordi Gali, and Mark Gertler (1999) and Michael Woodford (2003) provide a comprehensive overview of the issues and methods involved in studying monetary policy conduct from the New Keynesian perspective. The baseline version of the model has three sectors: households, firms, and the monetary authority. The first-order conditions from the household utility maximization problem give rise to the IS schedule that describes the equilibrium evolution of a measure of real activity or output gap, defined as the percentage deviation of actual output from potential, as a negative function of the real interest rate. By adjusting the nominal interest rate, therefore, the central bank can influence the level of real activity in the economy.
Monopolistically competitive firms set optimal prices for their output, with different firms resetting prices at different points in time, which gives rise to changes in relative prices of different outputs and hence welfare-loss-generating distortions that the policy maker is called to moderate.3 The first-order condition to this problem yields the New Keynesian Phillips curve (or the aggregate supply relation); a key feature of this structural equation is the presence of forward-looking, rational inflationary expectations. The baseline version of this Phillips curve takes the form
where π t is inflation, Bπ t+1|t is the expectation of next period’s inflation based on information available at the present time period, (yt – yt n ) is the (log) difference between actual and natural (or potential) output—or output gap—and et is the cost-push shock. The output gap term can be motivated by changes in the firm’s labor costs, whereas the cost-push shock is by changes in the markup that firms charge in excess of their labor costs. The presence of the expected inflation term is due to price stickiness modeled by the firm’s potential inability to change prices optimally in the future. Anticipating future inflationary pressures then enters the firms’ current pricing decisions and makes it important for the central bank to engage in managing inflationary expectations, as moderating those will result in lower inflation in the present.
Finally, the central bank needs to determine how the nominal interest rate is set in order to close this three-sector model. There are two ways of thinking about the conduct of monetary policy that have been widely used in the recent literature. One is due to the insight of John Taylor (1993), who pointed out that the Federal Reserve seemed to set the nominal interest in response to inflation and output gap. A number of empirical studies have confirmed that following this so-called Taylor rule has characterized the conduct of monetary policy in the United States in the recent past quite well. A large body of theoretical literature has shown that Taylor rules deliver macroeconomic stability in a variety of models.
Another way that monetary policy has been modeled is by assuming that the central bank minimizes a discounted stream of weighted averages of squared deviations of inflation from its target level and output from its target level (set at the potential level of output). Lars Svensson (2002, 2003) has been a particularly strong advocate of thinking about monetary policy in terms of minimizing volatility of inflation and output around their target levels rather than the mechanistic approach exemplified by Taylor rules. (Svensson calls the former targeting rules, because they are built around inflation and output targets, and the latter instrument rules, because they explicitly define the value of the nominal interest rate in terms of the other variables.) This setup places the conduct of monetary policy into a dynamic setting and offers a richer variety of insights.
One such key insight is the problem of the time inconsistency of optimal policy, originally pioneered by Finn Kydland and Edward Prescott (1977) and Guillermo Calvo (1978). Suppose that the economy experiences a positive transitory cost-push shock. The central bank can moderate its instant inflationary effect by promising to keep output below potential in the future time period. This reduces inflationary expectations and (partially) offsets the effect of the cost-push shock. Hence in the present, this shock will generate lower inflation and a smaller decrease in output below potential. In a way, the central bank commits to spread the real-economic pain from the cost-push shock over several time periods, even when the immediate impact of the shock is long gone. Although this policy generates optimal outcomes over the long haul, it does run into short-run difficulties. In particular, in the time period following the transitory shock, the central bank has no incentive to make good on its promise to generate a recessionary environment, which helped moderate inflationary expectations—that is, it has an immediate incentive to renege on its contractionary promise because the effects of the shock have already dissipated. But if it discretionarily reneges on its promise, once another cost-push shock materializes, it will not be able to pursue a dynamically optimal stabilization policy with any measure of credibility, hence generating worse macroeconomic outcomes from there onward.
Another implication that emerges out of the dynamic targeting setup is that, especially given the long and variable lags in the transmission of monetary policy through the economy, it makes little sense for a central bank to set the nominal interest rate in response to a small number of contemporaneous variables in a predetermined, mechanical fashion. Furthermore, given the forward-looking nature of macroeconomic agents, what may matter more for the successful conduct of monetary policy is not the current level of the nominal interest rate but its projected path over some future time horizon. Identifying such a path is impossible without first postulating a dynamic objective over which the central bank wants to optimize.
In practice, these challenges make it virtually impossible for a central bank to achieve its target with current inflation, and instead, it will target expected inflation some periods into the future. Targeting future inflation also gives the central bank greater flexibility in considering output volatility as well. Woodford (2003) explains,
The argument that is typically made for the desirability of a target criterion … with a horizon k some years in the future is that it would be undesirable not to allow temporary fluctuations in inflation in response to real disturbances, while the central bank should nonetheless provide clear assurances that inflation will eventually be returned to its long-run target level. (p. 292)
IT central banks seem to exhibit their most meaningful differences by the length of this lag. More “flexible” IT regimes accommodate some real shocks and often will not return inflation to its target for much longer than their “stricter” counterparts who target the earliest feasible date. Svensson (1998) estimates that this time range for meeting the target is anywhere from 1.5 to 2.5 years. (As discussed below this “flexibility” opens these central banks to the criticism that their policy making is actually arbitrary.) More flexible IT regimes may allow the monetary authority to give some attention to unemployment or a real objective while still promising a certain level of inflation in the long run. Additionally, they may also allow greater instrument stability, as wide swings in interest rates may be painful in themselves. To show how the central bank balances these additional criteria, the terms that characterize their stabilization can be added into the central bank’s objective function with weights to show their relative importance. In a more strict IT regime, other concerns have relatively low weights, so that it may worry about large swings in these variables, but it still chiefly focuses on inflation stabilization.
Some critics of IT insist that insofar as the duration of actual inflation being off its target is uncertain, IT affords the monetary authority too much flexibility and is therefore destabilizing. For instance, in his criticism, Benjamin Friedman (2004) invokes the Tinbergen principle, which holds that with only one independent instrument, the variables relevant to monetary policy can be expressed in relation to one particular variable. This means that when a shock hits, and output and inflation are both off their desired level, the transition path of output is dependent on the path of inflation, so by choosing how long inflation may be out of the target range, the central bank implicitly chooses how output will respond. Since IT states the target for only one variable—inflation—and fails to communicate the central bank’s preferences with respect to other variables of interest, it may be viewed as too opaque. This critique, however, does not breach the consensus view that IT is successful in augmenting the central banks’ transparency, accountability, and success in mitigating business cycle volatility.
Although a tremendous amount of progress has been made in identifying the chief challenges of monetary policy making and demonstrating the benefits of IT, there does not exist a universal consensus on the exact methods for the implementation of IT. The next section reviews the recent experience of different countries whose central banks have adopted IT. Despite considerable differences in implementing this policy, the picture that emerges from our description points to its success in achieving macroeconomic stability.
Implementing Inflation Targeting: Practice
New Zealand was first to set an explicit inflation target for the medium run. The Reserve Bank of New Zealand (RBNZ) had a wide-ranging mandate from a 1964 law that charged it with “promoting the highest degree of production, trade and employment and of maintaining a stable internal price level.” Inflation stayed in double digits for most of the 1970s and 1980s, a cumulative 480% between 1974 and 1988. But by the time IT was introduced in 1990, a period of very high interest rates had inflation mostly under control. Ben Bernanke, Thomas Laubach, Frederic Mishkin, and Adam Posen (1999) believe that this timing was important to build confidence in the IT framework, as the public did not blame the new policy regime for the induced tight monetary conditions.
The inflation target was in fact a range set by the government that gradually fell from 2.5% to 4.5%, to 1.5% to 3.5%, and finally to 0% to 2% after December 1993. Though the government held the central bank accountable to keep inflation in the middle of a range it set, the RBNZ enjoyed instrument independence—that is, the central bank could independently choose its policy for interest rate and exchange rates. The IT framework in New Zealand also evolved to become less strict, in that deviations are now allowed to persist longer than the initial yearly horizon.
IT in New Zealand was also pioneering in the degree of transparency and the central bank’s communication of its decision making to the public. The RBNZ is legally required to produce a Monetary Policy Statement twice a year that outlines policy decisions. It also publishes forecasts in an Annual Report, other research in an annual Bulletin and a bi-annual Financial Stability Report. Starting in 1996, it has released a Monetary Conditions Index to summarize its forecasts.
Despite the eventual success of IT, the RBNZ did initially encounter some difficulties in its implementation. It first tried using “headline” or all-goods consumer price index (CPI) but found this too volatile. The RBNZ developed a concept of underlying inflation similar to a core measure to avoid including prices that were themselves sensitive to the first-round effects of a cost-push shock. Unfortunately, the core’s components changed occasionally, making it somewhat ad hoc, and its time series was marked by definitional breaks. The relatively tight, certainly by the standards of a small open economy, inflation target range of 0% to 2% imposed additional challenges, as the RBNZ was occasionally forced to produce large swings in the interest rate in order to meet its objective. Several times, inflation breached its ceiling, which was lifted to 3% in 1997. Still, the experiment with IT at the RBNZ has undeniably been a success, as chronic and volatile inflation seems safely in the past.
In 1991, Canada was next in the steady succession of IT adopters, following an announcement by the head of its central bank and the Minister of Finance but without a legislative mandate, unlike in New Zealand. Prior to adopting IT, Canada’s experience with inflation was less extreme than New Zealand’s, but the 1989 inflation rate of 5.5% was deemed unacceptably high. As the policy was adopted, the disinflation was accomplished by high interest rates and a sharper than expected cyclical downturn; on the upside, however, IT accomplished low inflationary expectations. According to Gordon Thiessen (1999), the Governor of the Bank of Canada from 1994 to 2001, inflationary expectations did not fall because the bank promised it but because low rates of inflation were “realized”; however, the promise helped to entrench these gains:
It is unlikely that the 1991 announcement of the path for inflation reduction had a significant immediate impact on the expectations of individuals, businesses, or financial market participants. On balance, I think that it is the low realized trend rate of inflation in Canada since 1992 that has been the major factor in shifting expectations of inflation downwards. But the targets have probably played a role in convincing the public and the markets that the Bank would persevere in its commitment to maintain inflation at the low rates that had been achieved.
Canada’s IT regime focuses on the medium-term inflationary expectations because they are particularly susceptible to short-run shocks as a small, commodity-exporting economy like New Zealand. Following the RBNZ, the Bank of Canada excludes volatile components from their “core” price index that, in its judgment, are transitory. If these excluded shocks are mean-zero, then headline and core will move together in the medium term. This flexibility allows a central bank to avoid the adverse output implications of contractionary policy and is common among other IT regimes.
Canadian policy makers also emphasized a dialogue with the public, which has become important for the transparency of IT regimes. To help formulate policy response to inflationary expectations, they follow the Consensus Forecasts of market economists compiled by the private Conference Board of Canada. They have also geared their own publications to be easily digestible. The Bank of Canada produces the Monetary Conditions Index, a summary statistic for price-level determinants, and uses more charts in their Annual Report to encourage public confidence in the Bank’s ability to meet its IT responsibilities.
Following New Zealand and Canada, the ranks of inflation targeters swelled during the 1990s. The United Kingdom and Sweden experienced sharp downturns and high inflation in the early 1990s and adopted IT regimes shortly thereafter. On the other hand, Australia’s situation was similar to New Zealand’s—a 1991 recession reduced inflation before their IT regime was enacted. Thereafter, a slew of developing countries created explicit inflation targets, ranging from traditional inflationary basket cases, such as Israel and Brazil, to postsocialist economies, such as the Czech Republic and Poland. Each has its own idiosyncrasies: Some target all-items inflation (e.g., Israel and Spain), while others target an underlying or core measure (e.g., Australia and the Czech Republic). Table 37.1 summarizes the list of inflation targeters and the time of adoption of this policy.
The U.K. experience exemplifies the rationale for IT adoption in many industrialized countries. Following an inflationary bout in the 1980s, the British had stabilized their currency by tying it to the Deutsche Mark. But when large-scale speculation forced the authority to break their peg, the Bank of England experienced a great deal of exchange rate volatility and abruptly lost their intermediate target. To stabilize exchange rates and regain an anchor for price stability, they implemented a band for their medium-term inflation target and long-term goal of 2%. After Britain’s success, other developed countries, such as Finland, Spain, and Sweden, also adopted inflation targets in response to foreign-exchange pressure.
Transitional and middle-income countries often have more volatile macroeconomic conditions and so may have even more to gain from the stability that IT imparts. Brazil’s inflation has fluctuated wildly through its diverse monetary regimes. When its fixed exchange rate regime failed in 1999, it began IT as part of an International Monetary Fund program. In the market turmoil of 1997 to 1998, the Czech Republic’s exchange rate target became untenable, and it adopted IT. To fit the regime to postcommunist transition, the Czechs have introduced a net inflation index, which excludes administered, or controlled, prices. Poland and Hungary followed, trying to stabilize their inflation to better integrate with Europe. South Korea began its policy under considerable duress after its financial crisis in the late 1990s, whereas Israel was trying to lock in its already completed disinflation.
Though the list of IT countries is 26-strong, the so-called G3—the U.S. Federal Reserve, the ECB, and the Bank of Japan—are notably absent. This is especially ironic given the Fed’s long, (mostly) successful history of pursuing price stability and the enthusiasm for IT of its chairman, Ben Bernanke, during his distinguished stint as an academic economist. Despite the lack of a formal commitment to a clear inflation target, there has arguably been a progression toward the IT framework and greater transparency. In February 1981, the Supreme Court defended the Fed’s right to secrecy, saying, “At bottom, the FOMC [has] concluded that uncertainty in the monetary markets best serves its needs” (Merrill v. Federal Open Market Committee). By 2004, Bernanke described an “ideal world” in which “the Federal Reserve would release to the public a complete specification of its policy rule, relating the FOMC’s target for the federal funds rate to current and expected economic conditions, as well as its economic models, data, and forecasts.” Presently, this ideal has not been reached.
Along with increasing its transparency, the Federal Reserve has been edging toward a de facto target range. In 2002, the term comfort zone appeared in a New York Times headline (Stevenson, 2002) and has subsequently been used by the Fed governors themselves to describe their desired inflation level. Still, they seem to lack credibility in this target, as admitted by Bernanke (2004): “Today long-term inflation expectations in the United States remain in the vicinity of 2-1/2 to 3 percent, above the range of inflation that many observers believe to represent the FOMC’s implicit target.”
Table 1 Inflation Targeting—Time of Adoption and Target Range
Although much of the Fed’s attention during the later part of 2008 was dedicated to the ongoing financial crisis, the minutes of the December 16, 2008, Federal Open Market Committee meeting reveal the participants’ deliberation whether “a more explicit indication of their views on what longer-run rate of inflation would best promote their goals of maximum employment and price stability.” The financial market turmoil drove the nominal interest rate toward its lower limit of zero. An explicit positive target rate of inflation may be needed to keep the nominal interest rate positive in the wake of large negative demand disturbances, such as a financial crisis. Matt Klaeffling and Victor Lopez Perez (2003), for instance, find that the presence of the zero bound implies that the optimal rate of inflation should be somewhat higher than in its absence, even if higher long-term inflation generates stronger macroeconomic volatility.
The ECB also does not consider its policy to be an explicit inflation target but has announced that an inflation rate below 2% is desirable. It promises to direct its policy to protect this bound. The legal basis of the ECB is also similar to an inflation target, as Article 105(1) of the treaty establishing the European Community mandates price stability as “the single monetary policy for which [the ECB] is responsible.” But, in keeping with the flexibility under IT, its Web site notes that the ECB “typically should avoid excessive fluctuations in output and employment” (ECB, n.d.). The de facto similarity to a flexible IT regime leads some commentators to discuss the ECB as if it were one, although its own leadership rejects the label.
Arguing from the position of an ECB board member, Jürgen Stark (2007) suggested that part of the reason why the ECB does not explicitly join the ranks of inflation targeters is in order to preserve institutional continuity with its predecessors. The new authority wishes to be seen as inheriting the German Bundesbank’s tenacity in controlling inflation. With its current strategy, Stark argues, the ECB has more flexibility in medium-term and long-term objectives and in communication strategy, as it can put less emphasis on forecasts. With a firm record of keeping its informal target, perhaps the ECB has already attained the credibility that an IT regime hopes to create.
Many early adopters of IT have been quite successful under the new monetary regime, but it has proven difficult to take a definitive stance on its overall effect. Table 37.2 compares the summary statistics for measures of inflation and output growth for IT and non-IT countries. In the 10 years prior to IT, New Zealand averaged 10.8% inflation with a standard deviation of greater than 5%, 1.8% output growth with a standard deviation of 1.85%. From 1990 to 2006, inflation was below 2% with a standard deviation of about 1%, and growth was higher and less volatile, about 3% with a standard deviation of 2%. Similarly, since Canada stabilized its inflation target in 1995, inflation has been in its target 1% to 3% range almost continually, and its business cycles have been relatively mild.
Table 2 Real Output Growth and Inflation Volatility for Selected IT and Non-IT Countries
Even countries that have missed their inflation targets, as have many of the adopters in developing countries, have had relatively strong performances and have reformed their policy practices in the aftermath of IT adoption. The Czech Republic is a good example of this, as it severely undershot its target in 1998 and 1999. It later began targeting headline CPI, rather than a restricted core, and made the target more strict, by promising to hold it continuously rather than just at year’s end. In its first decade of IT, Czech output has been stable, averaging 4.1% with a standard deviation of 1.9%, and its inflation has been low and stable, averaging 2.1% with standard deviation 1.8%. Even when countries overshot their inflation targets, as Israel in 2002, the IT policy makers have been able to regain control. Despite very large exogenous shocks, the inflation spike was brief and has been within the target since, while real output growth has averaged over 5%.
Several attempts have been made to systematically study countries before and after implementing IT and to compare them to non-IT countries. This is complicated because in the 1980s, just before most targets were adopted, inflation and output performance was generally poor and volatile, while the 1990s were relatively prosperous and stable. It is difficult to isolate the IT effect from generally favorable world economic conditions in the experimenting countries. Laurence Ball and Niamh Sheridan (2005) use a panel regression approach with 20 Organisation for Economic Co-operation and Development countries, but find that an IT regime does not significantly improve the level or variance of output growth or inflation when they control for pre-IT conditions, which were generally worse in the adopting countries. However, Marco Vega and Diego Winkelried (2005), using a similar methodology but including developing countries into the sample, show that the policy regime choice does have a statistically significant effect. David Johnson (2002) finds that IT significantly reduced inflation expectations as measured by the average among professional forecasters. Frederic Mishkin and Klaus Schmidt-Hebbel (2007) find that IT reduces inflation levels and volatility and lowers interest rates, and this effect is stronger in industrial countries. More conclusive evidence about IT may only come with more practical experience and further academic effort.
The adoption of IT may very well be the most significant development in monetary economics over the last couple of decades. The number of central banks around the world that have officially adopted IT as the framework for their conduct of monetary policy has been steadily increasing. Although the time frame for evaluating the success of IT may be relatively short, the preliminary results that have emerged are encouraging. None of the IT adopters have abandoned this policy, and several central banks that have not formally announced IT as their policymaking framework have acted in a way that is fully consistent with it.
Although little theoretical literature on IT existed prior to New Zealand’s adoption of IT in 1990, the policy has been studied extensively in academia and in the central banks’ research departments. There may not be overwhelming consensus on the exact operational details of implementing IT in practice, but the general opposition to IT is rather slim. Given the international monetary trends in the past few decades, it seems reasonable to suggest that IT will continue to be the predominant paradigm for the conduct of monetary policy in the near future.
- Ball, L., & Sheridan, N. (2005). Does inflation targeting matter? In B. Bernanke & M. Woodford (Eds.), The inflation-targeting debate (NBER Studies in Business Cycles No. 32, pp. 249-276). Chicago: University of Chicago Press.
- Bernanke, B. S. (2004, January 13). Remarks by Governor Ben S. Bernanke. Speech at the Meetings of the American Economic Association, San Diego, California. Available from https://www.federalreserve.gov/boarddocs/speeches/2004/200401032/default.htm
- Bernanke, B. S., Laubach, T., Mishkin, F. S., & Posen, A. S. (1999). Inflation targeting: Lessons from the international experience. Princeton, NJ: Princeton University Press.
- Bernanke, B. S., & Woodford, M. (Eds.). (2006). The inflation targeting debate (NBER Studies in Business Cycles No. 32). Chicago: University of Chicago Press.
- Board of Governors of the Federal Reserve System. (2008, December 15-16). Minutes of Federal Open Market Committee. Available from https://www.federalreserve.gov/monetarypolicy/fomcminutes20081216.htm
- Calvo, G. (1978). On the time consistency of optimal policy in a monetary economy. Econometrica, 46(6), 36-48.
- Calvo, G. (1983). Staggered prices in a utility maximizing framework. Journal of Monetary Economics, 12(3), 383-398.
- Clarida, R., Gali, J., & Gertler, M. (1999). The science of monetary policy: A New Keynesian perspective. Journal of Economic Literature, 37(4), 1661-1707.
- European Central Bank. (n.d.). Objective of monetary policy. Available from https://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html
- Friedman, B. (2004). Why the Federal Reserve should not adopt inflation targeting. International Finance, 7(1), 129-136.
- Friedman, M. (1968). The role of monetary policy. American Economic Review, 58(1), 1-17.
- Greenspan, A. (2004). Risk and uncertainty in monetary policy. American Economic Review Papers and Proceedings, 94(2), 33-40.
- Johnson, D. (2002). The effect of inflation targeting on the behavior of expected inflation: Evidence from an 11 country panel. Journal of Monetary Economics, 49(8), 1521-1538.
- Klaeffling, M., & Lopez Perez, V (2003). Inflation targets and the liquidity trap (European Central Bank Working Paper No. 272). Frankfurt, Germany: European Central Bank.
- Kydland, F., & Prescott, E. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 8(49), 473-493.
- Merrill, D. R., v. Federal Open Market Committee of the Federal Reserve System. (1981, February). Defendant’s supplemental memorandum of points and authorities (United States District Court for the District of Columbia, Civil Action No. 75-0736).
- Mishkin, F. S., & Schmidt-Hebbel, K. (2007). Does inflation targeting make a difference (NBER Working Paper No. 12876). Cambridge, MA: National Bureau of Economic Research.
- Roger, S., & Stone, M. (2005). On target? The international experience with achieving inflation targets (IMF Working Paper WP/05/163). Washington, DC: International Monetary Fund.
- Rogoff, K. (1985). The optimal degree of commitment to an intermediate monetary target. Quarterly Journal of Economics, 100(4), 1169-1189.
- Stark, J. (2007, January 19). Objectives and challenges of monetary policy: A view from the ECB. Speech at a conference on inflation targeting, Magyar Nemzeti Bank, Budapest, Hungary.
- Stevenson, R. W. (2002, August 4). The Fed’s evolving comfort zone. The New York Times, p. B4.
- Svensson, L. (1998, Winter). Monetary policy and inflation targeting. NBER Reporter, pp. 5-8.
- Svensson, L. (2002). Inflation targeting: Should it be modeled as an instrument rule or a targeting rule? European Economic Review, 46(4-5), 771-780.
- Svensson, L. (2003). What is wrong with Taylor rules? Using judgment in monetary policy through targeting rules. Journal of Economic Literature, 41(2), 426-177.
- Svensson, L. (2008). What have economists learned about monetary policy over the past 50 years? (Sveriges Riksbank Press Release No. 39). Stockholm: Sveriges Riksbank.
- Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39(1), 195-214.
- Thiessen, G. (1999, March 11). Then and now: The change in views on the role of monetary policy since the Porter Commission. Speech at the C. D. Howe Institute, Toronto, Ontario, Canada.
- Vega, M., & Winkelried, D. (2005). Inflation targeting and inflation behavior: A successful story? International Journal of Central Banking, 1(3), 153-175.
- Woodford, M. (2003). Interest and prices: Foundations of a theory of monetary policy. Princeton, NJ: Princeton University Press.
- World Bank. (2008). National accounts and prices statistics. In World development indicators 2007. Available from https://openknowledge.worldbank.org/handle/10986/8150
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Fed’s rate hikes likely to cause a recession, research says
NEW YORK (AP) — Can the Federal Reserve keep raising interest rates and defeat the nation’s worst bout of inflation in 40 years without causing a recession?
Not according to a new research paper that concludes that such an “immaculate disinflation” has never happened before. The paper was produced by a group of leading economists, and three Fed officials addressed its conclusions in their own remarks Friday at a conference on monetary policy in New York.
When inflation soars, as it has for the past two years, the Fed typically responds by raising interest rates, often aggressively, to try to cool the economy and slow price increases. Those higher rates, in turn, make mortgages, auto loans, credit card borrowing and business lending more expensive.
But sometimes inflation pressures still prove persistent and require ever-higher rates to tame. The result — steadily more expensive loans — can force companies to cancel new ventures and cut jobs and consumers to reduce spending. It all adds up to a recipe for recession.
And that, the research paper concludes, is just what has happened in previous periods of high inflation. The researchers reviewed 16 episodes since 1950 when a central bank like the Fed raised the cost of borrowing to fight inflation, in the United States, Canada, Germany and the United Kingdom. In each case, a recession resulted.
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“There is no post-1950 precedent for a sizable ... disinflation that does not entail substantial economic sacrifice or recession,” the paper concluded.
The paper was written by a group of economists, including: Stephen Cecchetti, a professor at Brandeis University and a former research director at the Federal Reserve Bank of New York; Michael Feroli, chief U.S. economist at JPMorgan and a former Fed staffer; Peter Hooper, vice chair of research at Deutsche Bank, and Frederic Mishkin, a former Federal Reserve governor.
The paper coincides with a growing awareness in financial markets and among economists that the Fed will likely have to boost interest rates even higher than previously estimated. Over the past year, the Fed has raised its key short-term rate eight times.
The perception that the central bank will need to keep raising borrowing costs was reinforced by a government report Friday that the Fed’s preferred inflation gauge accelerated in January after several months of declines. Prices jumped 0.6% from December to January, the biggest monthly increase since June.
The latest evidence of price acceleration makes it more likely that the Fed will need to do more to defeat high inflation.
Yet Philip Jefferson, a member of the Fed’s Board of Governors, offered remarks Friday at the monetary policy conference that suggested that a recession may not be inevitable, a view that Fed Chair Jerome Powell has also expressed. Jefferson downplayed the role of past episodes of inflation, noting that the pandemic so disrupted the economy that historical patterns are less reliable as a guide this time.
“History is useful, but it can only tell us so much, particularly in situations without historical precedent,” Jefferson said. “The current situation is different from past episodes in at least four ways.”
Those differences, he said, are the “unprecedented” disruption to supply chains since the pandemic; the decline in the number of people working or looking for work; the fact that the Fed has more credibility as an inflation-fighter than in the 1970s; and the fact that the Fed has moved forcefully to fight inflation with eight rate hikes in the past year.
Speaking at Friday’s conference, Loretta Mester, president of the Federal Reserve Bank of Cleveland, came closer to accepting the paper’s findings. She said its conclusions, along with other recent research, “suggest that inflation could be more persistent than currently anticipated.”
“I see the risks to the inflation forecast as tilted to the upside and the costs of continued high inflation as being significant,” she said in prepared remarks.
Another speaker, Susan Collins, president of the Boston Fed, held out hope that a recession could be avoided even as the Fed seeks to conquer inflation with higher rates. Collins said she’s “optimistic there is a path to restoring price stability without a significant downturn.” She added, though, that she’s “well-aware of the many risks and uncertainties” now surrounding the economy.
Yet Collins also suggested that the Fed will have to keep tightening credit and keep rates higher “for some, perhaps extended, time.”
Some surprisingly strong economic reports last month suggested that the economy is more durable than it appeared at the end of last year. Such signs of resilience raised hopes that a recession could be avoided even if the Fed keeps tightening credit and makes mortgages, auto loans, credit card borrowing and many corporate loans increasingly expensive.
Problem is, inflation is also slowing more gradually and more fitfully than it first seemed last year. Earlier this month, the government revised up consumer price data . Partly as a result of the revisions, over the past three months, core consumer prices — which exclude volatile food and energy costs — have risen at a 4.6% annual rate, up from 4.3% in December.
Those trends raise the possibility that the Fed’s policymakers will decide they must raise rates further than they’ve previously projected and keep them higher for longer to try to bring inflation down to their 2% target. Doing so would make a recession later this year more likely. Prices rose 5% in January from a year earlier, according to the Fed’s preferred measure.
Using the historical data, the authors project that if the Fed raises its benchmark rate to between 5.2% and 5.5% — three-quarters of a point higher than its current level, which many economists envision the Fed doing — the unemployment rate would rise to 5.1%, while inflation would fall as low as 2.9%, by the end of 2025.
Inflation at that level would still exceed Fed’s target, suggesting that the central bank would have to raise rates even further.
In December, Fed officials projected that higher rates would slow growth and raise the unemployment rate to 4.6%, from 3.4% now. But they predicted the economy would grow slightly this year and next and avoid a downturn.
Other economists have pointed to periods when the Fed successfully achieved a so-called soft landing , including in 1983 and 1994. Yet in those periods, the paper notes, inflation wasn’t nearly as severe as it was last year, when it peaked at 9.1% in June, a four-decade high. In those earlier cases, the Fed hiked rates to prevent inflation, rather than having to reduce inflation after it had already surged.
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Myth and Reality in the Great Inflation Debate: Supply Shocks and Wealth Effects in a Multipolar World Economy
Jan 2023 | Macroeconomics
Working Paper By
- Research Director
- Professor Emeritus, University of Massachusetts, Boston
- Senior Lecturer of Economics, Delft University of Technology
A critical reappraisal of the case in favor of monetary tightening pressed by inflation hawks is overdue.
This paper critically evaluates debates over the causes of U.S. inflation. We first show that claims that the Biden stimulus was the major cause of inflation are mistaken: the key data series – stimulus spending and inflation – move dramatically out of phase. While the first ebbs quickly, the second persistently surges.
We then look at alternative explanations of the price rises. We assess four supply side factors: imports, energy prices, rises in corporate profit margins, and COVID. We argue that discussions of COVID’s impact have thus far only tangentially acknowledged the pandemic’s far-reaching effects on labor markets.
We conclude that while all four factors played roles in bringing on and sustaining inflation, they cannot explain all of it. There really is an aggregate demand problem. But the surprise surge in demand did not arise from government spending. It came from the unprecedented gains in household wealth, particularly for the richest 10% of households, which we show powered the recovery of aggregate US consumption expenditure especially from July 2021.
The final cause of the inflationary surge in the U.S., therefore, was in large measure the unequal (wealth) effects of ultra-loose monetary policy during 2020-2021. This conclusion is important because inflationary pressures are unlikely to subside soon. Going forward, COVID, war, climate change, and the drift to a belligerently multipolar world system are all likely to strain global supply chains.
Our conclusion outlines how policy has to change to deal with the reality of steady, but irregular supply shocks. This type of inflation responds only at enormous cost to monetary policies, because it arises mostly from supply-side difficulties that require targeted solutions. But when supply plummets or becomes more variable, fiscal policy also has to adapt: existing explorations of ways to steady demand over the business cycle have to embrace much bolder macroeconomic measures to control over-spending when supply is temporarily constrained.
- Wp 196 Ferguson And Storm Inflation Final Jan 2 Cor (pdf, 1.19 MB)
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Teaching about inflation expectations | bring fred into the classroom | march 2023.
- FRED Adds Indeed Index Data
- Teaching About Diversity in Data | Bring FRED into the Classroom | February 2023
- Teaching About Adjusting for Inflation | Bring FRED into the Classroom | January 2023
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Focus on Survey-Based Inflation Expectations
Read this Economic Brief from the Federal Reserve Bank of Richmond to learn about consumer-based surveys of inflation expectations and use the FRED graph below to compare survey responses with the actual consumer price index inflation rate.
From the FRED Blog
The post “ How to measure inflation expectations ” discusses how the Federal Reserve Bank of St. Louis uses data from the U.S. Treasury Department to calculate several breakeven inflation rates.
Quiz Yourself on Inflation Expectations
Q1. Hover the mouse pointer over the January 2023 date on the graph to read the data. What is the average expected inflation rate one year from that date?
Q2. As of January 2023, which is lower, the 2-year expected inflation or 3-year expected inflation?
Read this FRED Blog post to learn more about those data.
Q1. Compare the average 1-year inflation rate expected on February 2021 (the green line) with the annual consumer price index inflation rate registered on February 2022 (the blue line). Which one was higher?
Read this FRED Blog post to learn how the graph was created.
Q1. The graph shows an index measuring consumer expectations about future inflation rates in the euro area (19 countries). Increasing index values represent higher inflation expectations and decreasing index values represent lower inflation expectations. As of December 2022, are inflation expectations in the euro area (19 countries) rising or falling?
You can share these graphs with your students using this dashboard . To customize this dashboard, just click the “Save to My Account” button at the top of the dashboard.
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March 2023, no. 23-08, trade-offs in fulfilling the fed’s dual mandate.
This article discusses the trade-offs and impacts of inflationary environments given the dual mandate of the Federal Reserve. High inflation creates pricing distortions and leads to a tax on liquidity. Furthermore, it has direct redistributive impacts of inflation on wages, portfolios and contracts that are preset in dollar terms. The analysis concludes that while inflationary trade-offs are complex, keeping expectations anchored is a paramount objective for the Fed, since unanchored expectations make all the other trade-offs harder to navigate.
The Federal Reserve has a dual mandate of achieving low and stable inflation and maximal employment. While there does not appear to be a long-run trade-off between those objectives, they may come into conflict at shorter horizons. For example, an inflationary increase in the price of foreign goods may cause the Fed to choose between either accepting temporarily higher inflation or increasing interest rates, thus cooling down the economy and increasing unemployment.
Several considerations arise if one submits this choice to a cost-benefit analysis. On the one hand, higher unemployment implies loss of income for those who lose their jobs and potentially lower wages for those who keep them. On the other hand, higher inflation distorts the price system, corrodes nominal income and the value of nominal assets, and may become ingrained in expectations.
Assessing those trade-offs is further complicated by the fact that they affect people differently. This article will discuss these trade-offs and their potential impacts in greater detail, showing some of the complications in coming up with a strategy to battle inflationary environments.
Traditionally, relative price distortions were identified as a main cost of high inflation. The economy works best when prices reflect differences in the costs of producing different goods of similar quality. This provides consumers and firms with incentives to demand more goods and inputs that can be produced more easily, allowing the economy to produce more with less. Inflation impairs the ability of firms to set prices correctly, distorting those incentives.
Such pricing distortions may emerge because firms do not change their prices continuously, instead keeping them in place for discrete periods of time. For example, a coffee shop may have increased its prices last year, but it doesn't reprint its menu every day with new prices. As inflation progresses, that coffee becomes cheaper relative to other rising prices in the economy, until the shop introduces a new menu. Thus, such prices are considered "sticky."
Sticky prices imply that, as inflation increases, some firms will end up with prices below what would make the most sense for them. Then, when given the opportunity, these firms will increase their prices beyond what they might otherwise choose to account for future inflation. Thus, some prices will be too high (such as recently adjusted prices), and others will be too low (such as prices that haven't changed in a while). Consumers then shift toward firms that have taken longer to adjust their prices, rather than the ones that produce most efficiently. This affects the ability of the economy to produce efficiently.
A Tax on Liquidity
Another cost of inflation is increases in the cost of holding currency and other nominally denominated liquid assets. As inflation rises, those money balances become smaller in real terms.
When it becomes costly for firms and households to hold money balances, they change their behavior, perhaps by holding smaller currency balances. In turn, these smaller balances may cause:
- Households to tilt their consumption away from goods that require cash payments
- Firms to avoid using certain types of inputs
- Production to be allocated away from goods that can be produced most efficiently and toward those most easily purchased on credit
To illustrate the cost of eroding the real value of money balances, consider that the total value of U.S. currency in circulation is about $2 trillion, or close to 10 percent of GDP. An inflation increase from 2 percent to 8 percent corresponds to an added cost of close to 0.5 percent of GDP.
A strict focus on currency may, however, be too narrow: Checking accounts do not typically pay interest, and interest rates on savings accounts have increased by less than 30 basis points in the past year despite rising inflation and fed funds rates. Thus, these accounts do not have practical mechanisms to combat the erosion of their values, which could mean significantly increasing the costs of inflation on liquidity.
Redistributive Impacts from Inflation
Another consideration is that inflation has direct redistributive impacts to the extent that prices, wages and contracts are preset in dollar terms. Those impacts sum to zero by definition, implying that different economic agents face being either harmed or favored.
First, to the extent that wages are slow to adjust, rapid price inflation depresses real wages. This implies a redistribution from people who earn their income primarily from wages toward those entitled to the dividends of firms selling at newly increased prices.
This redistributive impact is disparate across workers. In particular, workers who consume goods with prices more sensitive to inflation will see their real income corroded more quickly. For example, the 2022 article " Do Black Households Face Higher and More Volatile Inflation? " notes that Black households, on average, devote more of their income toward goods with flexible prices such as food categories and energy, leaving these households more exposed to inflation fluctuations.
A second source of redistributive impact from inflation fluctuation stems from differences in household portfolios. An inflation surprise is most damaging to households with a large part of their assets in fixed-interest, long-term bonds. Those tend to be older households, who retain much of their retirement savings in such generally safe assets.
At the same time, they will tend to benefit households with large, long-run fixed-interest debts, such as mortgages. Those tend to be young households with relatively good prospects for lifetime income, as noted in the 2016 paper " Inflation and the Redistribution of Nominal Wealth ." Younger households are also more likely to hold a significant part of their assets in equity and housing, the values of which are less likely to be directly affected by inflation in that same way.
While potentially significant, these redistributive impacts are most likely to arrive in response to inflation surprises. If inflation is predictably high, annual wage adjustments and interest rates on fixed-income assets will likely reflect such higher inflation.
Inflation surprises, however, can mean upside or downside effects. The upshot is that — even if the one-off redistributive impact of inflation surprises has clear winners and losers — repeated surprises in both directions have a negative impact on all households by making their overall income and wealth less predictable.
Disparate Impact on Employment
The negative consequences of inflation uncertainty are balanced against the benefit of stabilizing employment and income. Those benefits may be very different across households, depending on their exposure to unemployment fluctuations.
When discussing this trade-off, it is important to emphasize that, since the stagflation of 1970s, the consensus position among macroeconomists is that loose monetary policy can easily lead to high inflation without persistent gains in lowering unemployment rates. Therefore, a guiding principle of post-1980s monetary policy has been that it should not be used to try to achieve permanently higher employment.
At the same time, monetary policymakers can choose how much to prioritize employment in responding to certain shocks. For example, the Fed will typically not attempt to offset temporary increases in food or energy prices, because doing so would tend to raise the unemployment rate. Therefore, while there does not seem to be a trade-off between inflation and unemployment, there is a stability trade-off between those two variables.
This stability trade-off is different for different households. One particularly stark example — highlighted by the 2022 working paper " Monetary Policy With Racial Inequality (PDF) " as well as my 2022 working paper " Minority Unemployment, Inflation and Monetary Policy (PDF) ," which I co-authored with Claudia Macaluso and Munseob Lee — is along racial dimensions. In the U.S., Black households face unemployment rates that are roughly twice that of White households. Furthermore, it holds not only over long periods of time but also across booms and recessions. Thus, for example, in a recession where the unemployment rate for White households climbs from 5 percent to 10 percent, the unemployment rate experienced by Black households rises from 10 percent to 20 percent. Therefore, while about 5 percent of White workers will lose their jobs and income, about 10 percent of Black workers will suffer the same fate.
It follows that higher inflation volatility may be a price to pay for more stable income and employment for all, but even more of a price borne by particularly disadvantaged groups with higher unemployment rates in general. However, the scope for such a strategy may be severely limited if occasionally high inflation leads agents to have doubts about the commitment of monetary policy to long-run price stability.
The trade-off between the stabilization of inflation and unemployment is not static but may depend on how agents form expectations. The reason is that inflation depends not only on the economic "slack" associated with unemployment rates or shocks to demand or supply for particular goods and services but also on future expected inflation. This follows from the fact that most firms adjust their prices infrequently. If firms expect inflation to be high in the future, they might adjust prices higher in anticipation.
In a 2007 speech, former Fed chair Ben Bernanke defined anchoring of inflation expectations through the way in which long-run inflation expectations react to incoming data: " If the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored."
This definition is a good fit for how the joint dynamics of inflation and unemployment changed between the 1970s and the 2000s. In the 1970s, fluctuations in unemployment were associated with changes in inflation, a relationship known as the accelerationist Phillips curve. One interpretation is that firms regarded any change in inflation as permanent and reacted accordingly when setting prices. Thus, when Paul Volcker increased interest rates in the early 1980s and unemployment surged, the momentarily low inflation rates caused by higher unemployment led firms to revise their future inflation expectations down, bringing about a persistent decline in inflation.
Conversely, the Fed had very little scope in those years for stabilizing unemployment in the face of inflationary shocks without fatally compromising its low-inflation objectives. For example, the impacts of the 1970s energy crisis on inflation were very persistent even though they were accompanied by recessions.
In contrast, inflation expectations were well anchored in the 2000s. This was highly beneficial, as it allowed the Fed to keep both inflation and unemployment stable in the face of wide swings in commodity prices that rivalled the ones observed in the 1970s.
Because it affects the Fed's ability to stabilize unemployment, unanchoring of inflation expectations is a concern that tends to trump all others. For a few decades preceding the pandemic, inflation expectations appeared to be very solidly anchored, allowing the monetary authority to focus on other concerns. As inflation surged post-pandemic, this has come back to the foreground.
There are several good reasons why low and stable inflation is desirable. High inflation tends to distort prices and incentives to hold cash and buy certain goods and services. Furthermore, unstable inflation generates uncertainty in income and wealth holdings.
On the other hand, policymakers are justified in accepting some inflation instability if this avoids such an excessive volatility in unemployment over the business cycle.
One complicating aspect is that the costs and benefits may be very different across households. Households that normally face high unemployment and hold little in nominal balances may be willing to accept inflation in a way that households with stable employment and large nominal positions may not. Similarly, households that more heavily focus their expenditures on goods that respond significantly to inflation (such as gas or food) may be more concerned about inflationary fluctuations.
The post-pandemic surge in inflation has generated renewed worries about unanchoring of expectations. As the discussion above makes clear, such concerns are justified, as unanchoring severely limits the Fed's ability to attain its objectives of stable prices and maximum employment. Such limits would be particularly harmful to households with high unemployment rates and a large fraction of their baskets dedicated to inflation-sensitive goods.
Felipe Schwartzman is a senior economist in the Research Department at the Federal Reserve Bank of Richmond.
To cite this Economic Brief, please use the following format: Schwartzman, Felipe. (March 2023) "Trade-offs in Fulfilling the Fed's Dual Mandate." Federal Reserve Bank of Richmond Economic Brief , No. 23-08.
This article may be photocopied or reprinted in its entirety. Please credit the authors, source, and the Federal Reserve Bank of Richmond and include the italicized statement below.
V iews expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.
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Housing Economics Research Publications
From Department of Housing, Local Government and Heritage
Published on 28 February 2023
Last updated on 28 February 2023
Department of Housing research papers
Joint department of housing/esri research papers.
The Department of Housing, Local Government and Heritage has an active housing economics research programme, as the department wishes to understand housing market conditions and outcomes to inform the development of policy measures in a complex area of public policy. There are two major strands to the department’s research activities.
Firstly, the department publishes research papers which have been authored by departmental staff, including analysis of the housing aspirations of renters and the downsizing preferences of mature homeowners. These papers include work undertaken in collaboration with the Irish Government Economic and Evaluation Service.
Secondly, the department operates a joint housing economics research programme with the Economic and Social Research Institute (ESRI). The output of the research programme has been a series of published papers concerning housing economics and related topics. The programme has also been widened to include research focused on spatial planning and related topics. Topics include housing market affordability, the sustainability of house prices, structural (i.e. demographic) housing demand, credit demand in the Irish mortgage market, implications of the Covid-19 pandemic on the Irish rental market, and rental inflation and price stabilisation policies.
The housing aspirations and preferences of renters
Attitudinal survey of mature homeowners
Social housing in the Irish housing market
Rental inflation and stabilisation policies: International evidence and the Irish experience
Irish house price sustainability: a county-level analysis
A county-level perspective on housing affordability in Ireland
Irish house prices: Déjà vu all over again
Exploring affordability in the Irish housing market
Exploring the short-run implications of the COVID-19 pandemic on affordability in the Irish private rental market
Credit demand in the Irish mortgage market: What is the gap and could public lending help
Adding a construction sector to COSMO: Structure and policy analysis
Regional demographics and structural housing demand at a county level
Should you have any queries concerning the department’s research programme or outputs, please contact Paul J Hogan at: [email protected]
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Queries. The Department of Housing, Local Government and Heritage has an active housing economics research programme, as the department wishes to understand housing market conditions and outcomes to inform the development of policy measures in a complex area of public policy. There are two major strands to the department's research activities.