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Saturday, April 24, 2010

Inflation Targets

Countries around the world hold a ‘low and steady’ level of inflation as sacrosanct. The USA announced this February that its inflation target would be 1.7-2% while the Bank of England has long sworn by its target of 2%. There are many reasons why people support these low targets. For one, those on fixed incomes are relatively protected as their real income isn’t greatly reduced. The low rate of inflation also allows time for the incomes of those people to respond. Also, high inflation may cause unions to lobby for higher wages, pushing up the costs of firms. This would reduce the competitiveness of exports – adversely affecting the balance of trade. As a result, there may be unemployment and the start of the negative multiplier effect.

However, there is a case for inflation targets to rise. Heavily indebted countries would benefit as the real value of their debt decreases. However, while doing so would rebalance the current account they could well alarm the creditor. A higher target rate of inflation would also justify the central bank cutting interest rates. As a result, people will take out more loans and be less inclined to save. Such expansionary monetary policy would spur economic growth and cause demand-pull inflation.

In addition, if the government announced an inflation target that is higher than usual, people may be compelled to expedite purchases that they had planned to make at a later date. This increase in consumer demand would not only serve to make firms employ more workers, but would lead to economic growth as firms expand their output.

Decreasing interest rates to push up inflation will also devalue the currency due to the increase in money supply and demand. This will cause exports to be more competitive. Consequently, the balance of trade may actually become more favourable as a result of inflation – contrary to the view expressed above by advocates of low inflation targets.

As mentioned above, one of the main arguments against targeting high levels of inflation has been that such high levels cause unemployment as firms can’t afford to hire as many workers at higher wages. However, if inflation is achieved through demand-side policy, rather than firms having to cut back on output and employment, they will need to increase employment – even at the higher wages. Hence, a higher level of demand-pull inflation may result in a decrease in unemployment. Moreover, even if firms need to reduce their labour costs, it is unlikely that they will need to lay off that many workers. This is because they will be able to mask real wage decreases by increasing wages at a rate lower than inflation.

In addition, if the government announced an inflation target that is higher than usual, people may be compelled to prepone purchases that they had planned to make at a later date. This increase in consumer demand would not only serve to make firms employ more workers, but would lead to economic growth as firms expand their output.

Furthermore, it is obvious that those who are hardest affected by rising inflation are those on fixed incomes such as pensioners and the unemployed. However, if there was higher inflation then there is likely to be a decrease in voluntary unemployment – a decrease in the number of people who choose to be unemployed because the unemployment benefits are generous enough that they have little incentive to work. This would be beneficial to the economy as it would lower the output gap and stimulate economic growth. Now, at first thought, many would assume that voluntary unemployment barely accounts for a fraction of total unemployment. However, in the US, voluntary unemployment has been hovering at between 10-15% over the last couple of decades. Clearly, it is a problem that needs to be tackled and inflation could be one way of doing so.

All in all, it seems that perhaps current inflation targets are too conservative. Countries clearly stand to gain from an increase in inflation targets. Unfortunately, such measures are unlikely to be put into practice as they hit pensioners the hardest. And pensioners, rather than younger people, are the ones who tend to vote.



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