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## The ISLM model in an Open Economy

The IS relation is flatter in the case of an open economy than a closed economy. This is because output is more sensitive to changes in the nominal interest rate, because we are taking net exports into account.

The uncovered interest parity condition, $(1+i_t)=(1+i*_t)\frac{E_t}{E^e_{t+1}}$, implies that, an increase in the domestic interest rate $i$ will increase the nominal exchange rate $E$ when other factors like the foreign interest rate $i*$ and the expected future exchange rate $E^e$. This means that the currency will appreciate in value.

Alternatively, a decrease in the domestic interest rate will decrease the nominal exchange rate, and mean that the currency will depreciate in value.

The IS relation is a downward sloping relation, meaning as the interest rate falls, output increases. In the closed economy this is simply due to the effect on investment, in the Keynesian model of aggregate demand Y = C + I + G, where I depends negatively on the interest rate. Lower interest rates mean businesses are more likely to invest and so I rises.

In the open economy we also start to consider net exports, so the Keynesian model of aggregate demand becomes Y = C + I + G + NX where NX (net exports) depends on domestic income, foreign income and the exchange rate. When domestic incomes are higher, imports will be higher. When foreign incomes are higher, exports will be higher. When the exchange rate rises, imports will be higher and exports lower because it becomes cheaper for domestic consumers to afford foreign goods whilst it becomes more expensive for foreign consumers to import the goods our economy produces. When the exchange rate falls, imports will be lower and exports higher because it becomes more expensive for domestic consumers to afford foreign goods so they substitute away from imports and instead purchase domestic produced goods. However foreigners will find the goods we produce cheaper so are likely to buy more of our exports.

A higher exchange rate (caused by a higher interest rate) means more imports and less exports, so NX falls and AD rises.

A lower exchange rate (caused by a lower interest rate) means less imports and more exports, so NX rises and AD rises.

This magnifies the effect interest rates have on output.

When interest rates fall, investment increases and net exports increase, so output increases by more in an open economy than it would in a closed economy.

When interest rates rise, investment falls and net exports fall, so output decreases by more in an open economy than it would in a closed economy.

This means the IS relation will be flatter in an open economy than in a closed economy.

The LM relation is unchanged in the open economy. Exchange rates do not affect demand for domestic money as foreign investors would rather hold interest bearing bonds than non interest bearing domestic currency anyway.

Categories: ISLM, Macro

## The Keynesian Cross in the Open Economy

The Keynesian Cross showed the relationship between planned expenditure and actual expenditure.

It was based on the Keynesian model of aggregate demand:

In the Keynesian model, demand is made up of consumption, investment, government spending, and net exports:

$Y=C(Y-T)+I(Y,r)+G+(X(Y*,\epsilon )-M(Y, \epsilon)$.

This is a fuller version of the Y=C+I+G+(X-M) that you will have seen at A-level, it just expresses what the components of AD are functions of:

In the context of the open economy we can expand our understanding of the Keynesian Cross by considering specifically the effect of exports and imports. Increasing exports adds to aggregate demand, whilst increasing imports decreases aggregate demand. So aggregate demand can be best thought of as the demand for domestic goods rather than the domestic demand for goods. That is, aggregate demand in an economy depends on the demand (both at home and abroad) for domestic produced goods, rather than the domestic demand for goods, some of which will be spent on buying imports that counts towards another economy’s aggregate demand.

We can therefore define three forms of demand:
DD – Domestic demand for goods (C + I + G + M)
AA – Domestic demand for domestic goods (C + I + G)
ZZ – Demand for domestic goods (C + I + G + Z)

Here we start with purple line DD, the domestic demand for goods, and subtract imports to get AA, the domestic demand for goods. Then we add exports, the equivalent of a vertical shift upwards because the demand for exports is exogenous and does not depend on domestic income like the other components of AD that increase with domestic income do. This gives us our ZZ line, the demand for domestic goods.

Now we can consider the implications of the DD and ZZ line, and whether it means we have a trade deficit or trade surplus. The ‘planned expenditure’ line in the Keynesian Cross corresponds to the ZZ line, really it is the ‘planned expenditure on domestic goods’.

The equilibrium comes at Y1, where the ZZ line intersects the 45 degree line. This is where demand for goods, Z, equals income, Y. But at this point, the DD curve is above the ZZ curve. This means the domestic demand for goods is higher than the demand for domestic goods, ie our economy’s citizens are demanding more goods than the demand for goods they produce. This means they must be importing more than they are exporting, and we have a trade deficit.

Again the equilibrium comes at Y1, where the ZZ line intersects the 45 degree line. This is where demand for goods, Z, equals income, Y. But at this point, the DD curve is below the ZZ curve. This means the domestic demand for goods is lower than the demand for domestic goods, ie our economy’s citizens are demanding fewer goods than the demand for goods they produce. This means they must be exporting more than they are exporting, and we have a trade surplus.

Categories: Aggregate Demand, Macro

## Disinflating the economy 2 – the role of expectations

The model of disinflation I created here relied on the concept of using unemployment to place downward pressure on inflation through tightening conditions in the labour market.

As such it was using a Phillips Curve like this: $\pi_t - \pi_{t-1} = -\alpha (u_t - u_n)$. This is an Expectations-Augmented Phillips Curve that assumes that agents in the economy base their expectations of inflation one year on what inflation was the previous year, ie $\pi^e = \pi_{t-1}$.

What about if we don’t make that assumption? Without that assumption, expected inflation replaces the term for inflation last year, so you have a Phillips Curve of $\pi_t - \pi^e = -\alpha (u_t - u_n) \Rightarrow \pi_t = \pi^e -\alpha (u_t - u_n)$. Now we can consider what would happen if agents expectations were based on something other than just inflation last year.

This economy has the following properties:

Normal output growth rate is 2.5%: $\bar {g_y} =0.025$.
Natural rate of unemployment is 5%: $u_n = 0.05$.
Okun’s Law parameter is 0.4 so $u_t - u_{t-1} = -0.4(g_{yt}-0.025)$.
Phillips Curve parameter is 0.75 so $\pi_t - \pi_{t-1} = -0.75(u_t - 0.05)$.

Lets say we start off in Year 0 with a medium run equilibrium, with nominal money growth at 7%. Inflation equals nominal money growth minus the growth rate of output so Year 0 inflation is 0.07 – 0.025 = 0.045, we are starting off with inflation at 4.5%.

Suppose the target is to bring inflation down to 2.5%, so the central bank will want to tighten monetary policy.

Lets say that this time, the central bank’s promise to bring inflation down to 2.5% was taken credibly by the agents in the economy. So their expectation of inflation in Year 1 was not simply that it would be 4.5% like last year, lets suppose everyone thought that they would probably be able to drive inflation down to something like 3%. So expected inflation was 3%. This means the Phillips Curve is actually $\pi_t = 0.03 -0.75(u_t - 0.05)$

In the model last time, the central bank started off by reducing money growth to 4.4% which meant output growth fell to 0.5% and unemployment rose to 5.8% in Year 1, in order to start getting inflation down (it fell to 3.9% in year 1, so there was still much work to be done).

Now this time because of the ‘credibility’ that the bank has, and the fact agents’ expectations are lower, it can be a little less drastic in its approach.

Remember we combined the equation that links nominal money growth, output growth and inflation: $g_{yt}=g_{mt}-\pi_t$ with Okun’s Law $u_t - u_{t-1} = -\beta (g_{yt} - \bar{g_y})$ to get $u_t - u_{t-1} = -\beta (g_{mt}-\pi_t - \bar{g_y})$.

Then substituted the values to get: $u_t - 0.05 = -0.4 (0.044-\pi_t - 0.025) \Rightarrow u_t = 0.0424 + 0.4\pi_t$.

So we have a value for $u_t$ that we can sub into the new Phillips Curve to get:
$\pi_t = 0.03 - 0.75(0.0424 + 0.4\pi_t - 0.05)$ so $\pi_t = 0.03 - 0.75(0.4\pi_t - 0.0076) \Rightarrow \pi_t = 0.0275$. Inflation has fallen to 2.75%. This is much further than the fall to 3.9% it had done in the first example.

Now subbing that in to the expression we had for unemployment we get that $u_t = 0.0424 + 0.4 (0.0275) = 0.0534$ so unemployment is rising to 5.34%. Compare this to 5.8% in the first example.

We can also sub the value for inflation into the expression $\pi_t = g_{mt} - g_{yt}$ to get $0.0275 = 0.044 - g_{yt} \Rightarrow g_{yt} = 0.0165$ so output growth is 1.65%. Compare this to 0.5% in the first example.

So lets take stock of what has happened this time as a result of the central bank’s tightening of monetary policy by reducing nominal money growth to 4.4%. Because agents in the economy were expecting inflation to fall anyway (to 3%), the tightening of monetary policy worked much more effectively and involved less of a trade off with unemployment and output growth. Growth did not fall by as much and unemployment did not rise by as much. And with inflation already down to 2.75%, it would not take much more tightening next year to hit the 2.5% target.

The moral of the story is that if you can establish credibility and get agents in the economy to believe that you are going to bring down inflation, you can do it with much less pain in terms of unemployment and output growth. This is part of the reason why a stated central bank target can be a good idea – it lends some credibility to the fact you are working your monetary policy towards a target. But if you keep missing the target, then that credibility will disappear.

Categories: Macro, Monetary Policy

## The Uncovered Interest Parity Condition

There is no point choosing to hold foreign money over domestic money – if you aren’t going shopping abroad there is nothing you can do with foreign money. But you may be interested in holding foreign interest-paying assets.

Consider the option of holding US and UK bonds. If the rate on UK bonds this year is $i_t$ then if you buy a UK bond, in a year’s time it will be worth $1+i_t$. If instead you spend the same amount of money that you would use to buy a UK bond, on US bonds, you would be able to get $E_t$ US bonds. If the rate on US bonds was $i*$ then you would get $E_t(1+i*)$ in a year’s time. But you would have to convert this back into pounds, so you would have to divide it by the exchange rate in a year’s time. So your overall return would be $\frac{E_t(1+i*)}{E_{t+1}}$.

Arbitrage will dictate that if both US and UK bonds are selling on the markets, that the expected return for both must be the same according to the uncovered interest parity condition:

$(1+i_t)=(1+i*_t)\frac{E_t}{E^e_{t+1}}$.

Say the spot (current) exchange rate was £1=$1.62. The markets expect that in a year’s time, the exchange rate will be £1=$1.64. US bonds pay a rate of 3.2%. The UIP condition will imply that $(1+i_t)=(1.032)\frac{1.62}{1.64}=1.01941$ so UK bonds would pay a rate of 1.94%.

Say you had £100. You could buy £100 of UK bonds and after a year they would be worth £100 x 1.01941 = £101.94. Alternatively, £100 could buy you £100 x 1.62 = $162 of US bonds now. In a year’s time they would be worth$162 x 1.032 = $167.184. When you converted that back into pounds (assuming the exchange rate was the same as had been expected) you would have 167.184/1.64 = £101.94. If the expected exchange rate next year was £1=$1.64 and UK bonds paid an interest rate higher than 1.94% then nobody would hold US bonds, they may as well hold UK bonds instead. If UK bonds paid an interest rate lower than 1.94% then nobody would hold UK bonds, they may as well hold US bonds. The fact that both are selling on the markets implies that arbitrage has equalised their expected return – although individual buyers may choose UK or US bonds because they expect that the exchange rate will be higher or lower than the general market expectation.

The UIP relation plays a central role in the real world workings of currency fluctuations. It says that the nominal exchange rate will rise if the domestic interest rate rises, or if the future expected exchange rate rises. It will fall if the foreign interest rate rises.

When rates are small we can make an approximation to the UIP condition:

$i_t \approx i*_t - \frac{E^e_{t+1}}{E_t}$

ie the domestic interest rate = foreign interest rate minus expected appreciation of the domestic currency

There are a few assumptions contained in the UIP – investors are assumed to always
want to hold the bonds with the highest expected return, and take no account of the relative risk. There are also assumed to be no transaction costs. And we are taking the expected future exchange rate as exogenous.

Categories: Exchange rates, Macro

## Real exchange rates

Some goods (eg cars, computers) are called tradable goods because they can be traded between countries, and consumers in one country have the choice of buying domestically produced goods or importing them from foreign firms. Other goods (eg tourism, haircuts) can’t be traded and so are non-tradable goods.

Usually smaller countries have higher percentages of their GDP that are made up of imports/exports, they must specialise in what they are good at and rely on imports for other products.

For consumers, the choice between buying domestic or foreign goods depends on the relative prices, any tariffs which distort the relative prices, and the real exchange rate (purchasing power in terms of goods of one currency in another).

The real exchange rate is the nominal exchange rate multiplied by the ratio of price levels:

Real exchange rate: $\epsilon = \frac{EP}{P*}$.

This notation is saying the real exchange rate is equal to the nominal exchange rate multiplied by the domestic price level, divided by the foreign price level.

The nominal exchange rate is simply the rate at which you trade one currency for another, eg £1:€1.13 is a nominal exchange rate saying you get 1.13 Euros to the Pound Sterling.

If the real exchange rate is high, foreign goods are relatively cheap and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive and domestic goods are relatively cheap.

Think in terms of one good, eg imagine the same type of car costs £8000 or €9000. The nominal exchange rate is £1=€1.14. So the real exchange rate is $\epsilon = \frac{1.14(8000)}{9000}=1.013$. In other words, we can exchange 1 British car for 1.01333 European cars. Now imagine a year later, the nominal exchange rate is £1=€1.26. The car sells in Britain for £8300 and in Europe for €9600. Now the real exchange rate is $\epsilon = \frac{1.26(8300)}{9600}=1.0894$. which means that now we can exchange 1 British car for 1.0894 European cars. The good in question (the car) now exchanges on better terms for British customers.

We can extend this principle to thinking of a generic basket of goods. Imagine a general basket of goods in the UK being given an ‘index’ of 100. If the same basket of goods in the US was 98 then we could conclude the basket was slightly cheaper in the US. Assume the nominal exchange rate is £1=$1.62. So the real exchange rate is $\epsilon = \frac{1.62(100)}{98}=1.653$. Because we are using index numbers, on its own this figure is arbitrary and uninformative. All it tells us is that in terms of the basket of goods we are comparing, £1 would buy$1.65306 worth of goods. Now imagine inflation in the UK is 4% and in the US is 2%, but a year later, the nominal exchange rate stays the same, £1=$1.62. Now the real exchange rate is $\epsilon = \frac{1.62(104)}{99.96}=1.685$. Now £1 would buy$1.685 worth of goods in the US, which sounds like it is a better deal for UK consumers, yet inflation has been higher here than in the US? This is because we kept the nominal exchange rate the same. We can consider what would happen if we assumed the real exchange rate stayed the same and the nominal exchange rate adjusted to reflect the differing levels of inflation in each country.

You can rearrange the real exchange rate formula to give $E = \frac{\epsilon P*}{P}$ so if we assume the real exchange rate in our example stayed the same, then $E = \frac{1.653(99.96)}{104}=1.588$. So as a result of the higher inflation in the UK compared to the US, the pound has fallen against the dollar. You now don’t get as many dollars for each pound as you did before, assuming the purchasing power in terms of goods has stayed the same in the two countries.

In practice there are likely to be shifts in both the nominal and real exchange rate.

If the real exchange rate appreciates or depreciates against another currency over time then that tells us that goods are less or more expensive in one country against another. The real exchange rate is basically a relative price and so it affects the demand for goods. If the real exchange rate is low then domestic goods are relatively cheaper so imports are likely to be lower and exports are likely to be higher. If the real exchange rate is high then foreign goods are relatively cheaper so imports are likely to be higher. In the example before of the cars, the rise in real exchange rate for British consumers means they will probably import more cars from Europe in the second year than they did in the first.

Categories: Exchange rates, Macro

## Disinflating the economy 1 – a model of disinflation

We can see how disinflation would work in practice by using a fantasy economy. This is a little model economy using the Phillips Curve and Okun’s Law equations, to see how you can disinflate an economy through tighter monetary policy (reducing the rate of nominal money growth). We are using the principle here that $\pi_t = g_{mt} - g_{yt}$.

This economy has the following properties:

Normal output growth rate is 2.5%: $\bar {g_y} =0.025$.
Natural rate of unemployment is 5%: $u_n = 0.05$.
Okun’s Law parameter is 0.4 so $u_t - u_{t-1} = -0.4(g_{yt}-0.025)$.
Phillips Curve parameter is 0.75 so $\pi_t - \pi_{t-1} = -0.75(u_t - 0.05)$.

Lets say we start off in Year 0 with a medium run equilibrium, with nominal money growth at 7%. Inflation equals nominal money growth minus the growth rate of output so Year 0 inflation is 0.07 – 0.025 = 0.045, we are starting off with inflation at 4.5%.

Suppose the target is to bring inflation down to 2.5%, so the central bank will want to tighten monetary policy. Suppose they decide in Year 1, to reduce nominal money growth down to 4.4%.

You can combine the equation that links nominal money growth, output growth and inflation: $g_{yt}=g_{mt}-\pi_t$ with Okun’s Law $u_t - u_{t-1} = -\beta (g_{yt} - \bar{g_y})$ to get $u_t - u_{t-1} = -\beta (g_{mt}-\pi_t - \bar{g_y})$.

We could substitute our values here to get: $u_t - 0.05 = -0.4 (0.044-\pi_t - 0.025) \Rightarrow u_t = 0.0424 + 0.4\pi_t$.

Now we have got a value for $u_t$ we can sub this into the Phillips Curve to get: $\pi_t - 0.045 = -0.75(0.0424 + 0.4\pi_t - 0.05)$ so $\pi_t = 0.045 -0.75(0.0076 + 0.4\pi_t) \Rightarrow 1.3\pi_t = 0.0507 \Rightarrow \pi_t = 0.039$. So we have found inflation in Year 1 to be 3.9%.

We can sub this value back into the Okun’s Law expression: $u_t = 0.0424 + 0.4(0.039) \Rightarrow u_t = 0.058$. So we have found unemployment in Year 1 to be 5.8%.

We can also sub the value for inflation into the expression $\pi_t = g_{mt} - g_{yt}$ to get $0.039 = 0.044 - g_{yt} \Rightarrow g_{yt} = 0.005$ so output growth is 0.5%.

So lets take stock of what has happened as a result of the central bank’s tightening of monetary policy by reducing nominal money growth to 4.4%. The reduction in money growth has reduced output growth from the normal rate of 2.5% down to 0.5% (the mechanism by which it will have done this will be through the reduction in money growth raising interest rates and reducing investment, it is like a monetary contraction in the ISLM model). The reduction in output growth below the normal rate of output growth has raised unemployment to 5.8% and this has tightened conditions in the labour market so that it has pushed downward pressure on inflation down to 3.9%. Inflation has come down at the cost of some more unemployment, but we are still a way off the target of 2.5%.

Let us suppose in Year 2 the bank chooses a nominal money growth level of 5.15%. I won’t bother going through all the calculations here, I will just show the results. This level of nominal money growth now pushes output growth back up to 2%, but this is still below the normal growth rate of output, so unemployment rises to 6%. This continues to put downward pressure on inflation to bring it down to 3.15%. Remember that any time the unemployment rate is above the natural rate of unemployment, it applies downward pressure to inflation.

In Year 3 suppose the bank chooses a nominal money growth target of 5.35%. Now output growth is allowed to rise to 2.85%, and unemployment rate falls back a little to 5.86%. But as unemployment is still above the natural rate, inflation continues to fall, down to 2.5%. Now the central bank has achieved its target rate of inflation.

If it kept a tight monetary policy then it would carry on forcing inflation down but at the cost of higher unemployment, so suppose the bank relaxes monetary policy and allows money growth of 7.15% in Year 4. This allows the economy to boom, growing at 4.65%, and the extra output growth leads to a surge in firms hiring workers, so unemployment falls to 5%. As this is now the natural rate of unemployment, it keeps inflation constant, so it stays at 2.5% (this is why I chose the level of 7.15% money growth, because it would hit the natural rate of unemployment!). Now the bank is back to equilibrium level of unemployment, all it needs to do is stay there. So in Year 5 it has money growth of 5%, which will return output growth to the normal growth rate of output (as 0.025 = 0.05 – 0.025), and it keeps the rate of unemployment constant at the natural rate, and also keeps inflation constant at 2.5%.

So after this four year policy, we have got inflation down and returned unemployment back down to the natural rate. Inflation was brought down by accepting some higher unemployment in the short term, but once the economy has been disinflated, all that is needed is to keep the economy back on track at its equilibrium levels of output growth and unemployment, to keep that inflation constant.

Categories: Macro, Monetary Policy

## Is zero inflation optimal?

Discussion on the ‘costs of inflation’ is a staple of A level Economics courses. You have probably heard these arguments before:

Shoe leather costs – as inflation rises and money becomes worth less, you have to take more trips to the bank so are wearing out your ‘shoe leather’ (really the cost here is the cost of your time rather than your shoes unless you are wearing really flimsy shoes).
Menu costs – as inflation rises and firms have to change their prices more often, they incur costs reprinting menus, catalogues etc.
Tax distortions – the classic case is ‘fiscal drag’ – governments usually set and fix tax bands at the start of the financial year, so if prices are rising sharply that has a distortionary effect, eg if higher rate income tax kicks in at £40000 a year, and you are earning £35000 a year in an environment where there is 20% inflation, your employer might give you a pay rise to keep pace with inflation putting you on £42000 – in real terms that is just the same as earning £35000 a year ago, but now you have suddenly become a ‘high rate’ tax payer. This also happens for capital gains tax, when people sell assets like houses that have appreciated in value due to high inflation, the tax paid becomes disproportionately high.

These answers will probably get you marks in an A level exam but in the modern economy these aren’t major issues unless you get into hyperinflation territory. There is so much electronic banking these days that shoe leather costs are minimised, and many businesses, especially in retail, change prices all the time anyway regardless of inflation, cycling offers and discounts to attract customers. Many do business on the internet as well where it’s easy to change your menus. So the menu costs are not massive. As for tax distortions they are a real nuisance but they could easily be dealt with if the government just changes their tax rules to be indexed to inflation. The fact they don’t is probably because the government is usually the one who benefits from fiscal drag anyway so they will just take the extra tax revenue (in an environment of high inflation they want to take all the benefits they can get).

Here are the big problems that come from inflation being high:

Money illusion – price signals break down when people lose their ability to judge and compare prices over time. This sounds like such a basic fact but it underpins the whole market economy. Lets say for example you decide to go shopping for some Levis jeans. Say last time you went looking for jeans was eight months ago, you saw Levis were around £80 so you will have this kind of idea in your mind as to the price of Levis. If we are in a low inflation environment (say 2%) and you see some Levis in a shop at £90 then you will have an instinctive feel for the fact that is probably pricey and you can get it elsewhere. If the market price was £80 eight months ago and inflation is 2% per year then that means that every month prices will be rising $1.02^\frac{1}{12}=1.00165$ in other words they are rising 0.165% per month, so after eight months you would expect the market price to be $80(1.00165^8 )=81.06$. This is basically a stable price, so your ‘feel’ for the market price as being £80 will be more or less right.

Now think of that scenario but in an environment where inflation is running at 60%. Say you see some jeans on offer for £105, is that a good deal or a bad deal. That is quite hard to do in your head – you have to make an ‘educated guess’ and you could be right or wrong.

If you actually had a calculator, and knew what you were doing in terms of compound interest, you could say that 60% inflation means $1.6^\frac{1}{12}=1.0399$ ie prices are rising 3.99% per month, so after eight months you would expect the market price to be $80(1.0399^8 )=109.44$. So in this case an offer of £105 is good, they are below the market price in real terms. But you aren’t going to do that in your head so you have lost the instinctive feel for prices.

This is what happens when inflation gets high, and the higher inflation is the more people lose their ability to compare prices, so it undermines the whole ability of firms to compete with each other on prices, and prices lose their ability to signal scarcity.

Inflation variability – generally low inflation means stable inflation and high inflation means variable inflation from one year to the next. Inflation in the UK (the RPI) from 1997 to 2005 was 3.3%, 2.4%, 2%, 2.7%, 1.3%, 2.9%, 2.6%, 3.2%, 2.4%. Compare this to the period between 1973 and 1981: 12%, 19.9%, 23.4%, 16.6%, 9.9%, 9.3%, 18.4%, 13%. Instead of varying by 1-2% per year, it is jumping around in variations of 5-10% per year. And this is the UK, which has traditionally been a low or medium inflation economy, the figures for some Latin American countries would dwarf that for variability. Variability is a problem because businesses need to plan for inflation when they set their wage levels, set their prices, sign contracts with suppliers etc. If you get it wrong by a percent or so its not too bad but if you think inflation will be 10% higher than it ends up being, and you have set your prices accordingly, you could be in for a big loss. The result is when inflation is high, firms do less investment and think more ‘short term’ rather than planning for the long term.

On the other hand there are some ways in which having some inflation is preferable to none.

Wage flexibility – generally wages are ‘sticky downwards’, which means that you very rarely get pay cuts in nominal terms, apart from in the more flexible parts of the private sector. Trying to cut workers’ wages in nominal terms stirs up a hornets nest of legal challenges and trade union action, so a pay freeze is about as strict as you usually get. Sometimes in a benevolent economic environment, especially when there is an unsustainable boom, wages can jump ahead of productivity, which means there will be problems down the line, not least in the context of international trade where a country with firms paying wages above its level of productivity will lose competitiveness to international competitors. So you need wages to adjust downwards, which is a slow and painful process – and the lower inflation is, the harder this is. You don’t actually need high inflation to carry out an adjustment, just a medium level. In the UK for instance, the government announced a three year public sector pay freeze in 2010. If inflation during that period runs at 4% then that means in real terms wages will fall by close to 12%, so that is an effective way of bringing wages back down in line with productivity. But if inflation was creeping around 1-2% it would take much longer to get the same adjustment.

Option of real negative interest rates – this is a big one when the economy is in trouble, particularly in the face of a liquidity trap. The issue here is that nominal interest rates can’t fall below 0%, but what influences investment is not nominal but real interest rates. As $r \approx i - \pi$. you can stimulate investment by pushing down real interest rates through higher inflation, when nominal interest rates are 0%, real interest rates can be $- \pi$. Again you don’t want to trigger hyperinflation in order to break out of a liquidity trap, but you might find inflation of 5-6% useful, rather than 1-2%.

Seignorage revenue -fraught with danger this one, because it can easily be misused and trigger an inflationary spiral. However for a developing country where it is difficult to collect taxes, seignorage revenue can be an important part of government revenue.

So what is the optimal level of inflation? There isn’t a set guide and it depends on opinion. By and large most Western democracies aim for low levels around about 1.5-2%. There are some that argue you should try to push inflation down to as close to 0% as possible, and there are others that argue some of the excessively tight monetary policy used to keep inflation low is counterproductive, and that there is nothing really wrong with inflation at 4-6%. Certainly the real negatives of inflation don’t kick in till you get higher rates (eg double figures).

The big danger with inflation though is its tendency to accelerate out of control, so once you get to 10%, it can quickly start to creep up towards 15-20% and beyond, where negatives do start to mount up.

Categories: Macro, Money