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Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]
Module: 4 Monetary Policy and Inflation
Global Inflation Experience
Box IV.1
Growth-Inflation Trade-off
The possibility of a trade-off between inflation and output was first highlighted by Phillips (1958) who found a negative relationship between wage inflation and unemployment behaviour for the UK economy. While this gave an impression that the inflation-output trade-off, later known as the Phillips Curve, could be stable, Friedman (1968) and Phelps (1967) were strongly critical of the possibility of a stable long-run trade-off. In particular, both of them stressed that the tradeoff would vanish once the role of expectations is incorporated in the simple Phillips Curve. The expectations augmented Phillips Curve would not be upward sloping; rather, it would be vertical at the economy's natural rate of unemployment, indicative of no long-run trade-off. The attempts of monetary authorities to reduce unemployment below its natural rate (alternatively, to increase output above its potential) would be reflected in higher inflation. The predictions of Friedman-Phelps were fully supported by the developments in the early 1970s as higher inflation was not accompanied by output gains; rather, the phenomenon of stagflation - higher inflation and lower output - was witnessed. While the Friedman-Phelps view discounted the proposition of a long-run trade-off, the possibility of even a short-run predictable trade-off also came under attack with the onslaught of rational expectations school of thought. The short-run trade-off continues to remain an issue of contention.
A short-run trade-off can arise on account of nominal and real rigidities in the economy (the New Keynesian perspective) or imperfect information (Lucas, 1973). In the latter view, as in 'misperceptions' model or 'signal extraction problem' of Lucas (1973), quantity supplied is a function of relative price movements (prices of firms' own goods vis-a-vis that of overall prices in the economy) but economic agents have imperfect information on aggregate price level movements in the economy. If the agents perceive the movements in the prices of their own goods as reflecting relative price movements, nominal demand shocks originating from monetary policy would have real impact leading to an observed trade-off. On the other hand, if the agents believe that the movements in the prices of their goods are only mirroring the aggregate price level movements, i.e., they perceive no change in relative prices, nominal demand shocks will have no effect at all on real output and will lead only to changes in the prices. The trade-off, therefore, depends upon the perception of economic agents. If the past demand shocks have been large, economic agents may attribute all the price level movements to aggregate prices and perceive no relative price shocks. In this case, there are no real effects and no trade-off would arise. On the other hand, if the past nominal disturbances have been small, the price movements may be viewed as mainly reflecting relative movements which would lead to changes in real output and, hence, an observed trade-off. Even though models with rational expectations rule out a systematic short-run inflation-output trade-off, imperfect information produces the observed short-run trade-off.
In contrast to the new classical emphasis on flexible wages and prices, the New Keynesian view attributes the short-run trade-off to nominal and real wage rigidities in the economy that may arise on account of menu costs, overlapping contracts, asynchronised timing of price changes and aggregate demand externalities. Nominal rigidities can result from optimising choices of agents and the real effects of nominal demand shocks can be large even if the frictions preventing full nominal flexibility are small. Macroeconomic effects of such small rigidities can be substantial in the presence of externalities. In this framework, nominal shocks have real effects because nominal prices change infrequently. An increase in the average rate of inflation causes firms to adjust prices more frequently to keep up with the rising price level. In turn, more frequent price changes imply that prices adjust more quickly to nominal shocks, and thus the shocks have smaller real effects. Countries with lower inflation levels are, therefore, expected to have relatively flat short-run Phillips Curves and hence, higher trade-offs (higher sacrifice ratios) and vice versa. Thus, as in the Lucas model, real effects of nominal shocks arise, albeit for different reasons: while the imperfect information model focuses on the variability of nominal shocks, the new Keynesians focus on the level of average inflation in generating real effects. In brief, it is now recognised that there is no long-run trade-off. The short-run trade-off is, at best, temporary when the economy is adjusting to shocks to aggregate demand and that too as long as expected inflation is lower than actual inflation.
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Box IV.2
Monetary Policy in a Low Inflationary Environment
Inflation in a number of economies fell below one per cent in early 2003 and, in some cases, inflation even turned negative. This raised serious concerns about a generalised global deflation and its adverse consequences. In particular, the episode highlighted the limitations of monetary policy in countering deflation. The constraints on monetary policy arise due to a lower bound of zero on nominal interest rates and the concomitant 'liquidity trap'. Coupled with downward nominal wage rigidities, a lower bound of zero on nominal rate restricts the ability of the monetary policy to drive down real interest rates. Rather, with falling prices, real interest rates would increase and further reduce domestic demand leading to a vicious circle. Due to the zero interest rate floor, the probability of a deflationary spiral increases sharply - from nil for an inflation target of two per cent and above to 11 per cent when inflation target is zero (IMF, 2003). If the shocks are large, the deflationary spiral cannot be reversed by adjustment of the short-term nominal interest rate alone. Deflation's adverse effects also take place through financial fragility due to debt-deflation cycle - harm to bank's balance sheets from reduced collateral and from debtors' diminished ability to service loans and widening of risk premium on corporate bonds in view of worsening balance sheets.
In view of these adverse consequences, the first principle is to avoid the deflationary spiral itself and this can be done by having an inflation target 'consistently on the high side of zero'. Central banks have, therefore, generally adopted inflation targets - whether implicit or explicit - of around two per cent. Furthermore, central banks and fiscal authorities should be prepared for the worst and accordingly make advance contingency plans for a series of emergency measures (Svensson, 1999). These measures could include:
In an environment of low inflation, central banks should take sufficient insurance against downside risks through a precautionary easing of monetary policy. Easing of fiscal policy to boost domestic demand. Open market purchases of long-term bonds (which would reinflate asset prices through portfolio rebalancing and the expectations channel and enable reduction in external finance premium), and, if need be, more unorthodox open market interventions in corporate bonds, property and stocks. Increase inflation expectations, i.e., "credibly promise to be irresponsible" (Krugman, 1998). Depreciation of the exchange rate coupled with a price level target path. Carry-tax on money (both reserve balances and currency) in order to lower short-term rates significantly below zero; an occasional carry-tax could be superior to perennially incurring a positive inflation rate. However, the possibility of currency substitution could weaken the efficacy of a tax on currency.
As the Japanese experience shows, deflation can be quite protracted and the efficacy of the above proposals is debatable. Since the ability of monetary policy to avoid or counteract the deflationary spiral is uncertain, a policy of prevention rather than cure has been stressed. Monetary policy should be non-linear, i.e., respond more aggressively to shortfalls of output from its potential than to a positive output gap so as to avoid deflationary spiral in the first place. This principle appears to have been the dominating feature of monetary policy reaction in response to the threat of deflation during 2003.
Central banks pursued aggressive easing of monetary policy. Short-term policy rates in a number of advanced economies were cut quite sharply to their record lows in the past four decades. For instance, the US Federal Reserve reduced the Federal Funds rate by 550 basis points from 6.5 per cent in November 2000 to one per cent by June 2003. Not only the actual rates were cut, the Federal Reserve committed itself to maintaining low rates "for a considerable period" to reassure financial markets and to keep inflation expectations stable. These measures appear to have succeeded in preventing the deflationary spiral. With a pick-up in economic activity and signs of incipient inflation, a number of central banks around the world started raising policy rates from late 2003 onwards.
Countries in Asia appear to be an exception and the inflation rates in these countries have been closer to that of the developed economies, reflecting fiscal prudence and sound macroeconomic management.
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