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INFLATION TARGETING AND OPTIMAL LEVEL OF ITSukumar NandiIndian Instutute of Management LucknowIndia

In a macroeconomics class, one studentasked, “What is inflation?” Beforeanswering the question, I took a little pauseand then gave the text book answer. Thestudent was not satisfied and that wasalong the line of my expectation and that iswhy I took a pause. Even today it is difficultto convince a student of a differentdiscipline about the nature of inflation.The reasons are not difficult to understand.Measuring inflation is a difficult task,though to make survey of prices ofcommodities over time is conceptually easy.But when that information is used to makesome index, problems emerge from twosources. First, price movements may be atransitory phenomenon, or noise. Sources ofsuch noise may be seasonal pattern,resource shocks, exchange rate changes, orasymmetric price adjustments. But noiseshould not affect policy makers’ actions.The second problem comes out of biasesthat are consequences of weighting pattern,sampling technique or quality adjustmentused for price calculations. The problems ofbiases is much more important compared tothe existence of noises in the sense thatcentral bank’s particular target of inflationand the monetary policy attuned to thattarget may be influenced by that bias(Shapiro and Wilcox, 1998).The monetarist theory of inflation explainsthat more than optimum amount of supplyof money will induce demand expansionand that additional demand will beliquidated by an overall increase in prices ofcommodities. This demand-pull inflationhas the problem that all commodities maynot get price hike and also the price increasemay not be at the same rate.In 1960s economists discovered thatinflation may be possible even withoutincrease in money supply and they camewith the idea of cost-push inflation. Buthow cost escalation starts leading to pricerise, remains a naughty question.If we collect data for a long list ofcommodities for the last twenty years, wewill see that real prices of manycommodities have gone down (electronicsand many consumer goods), while prices ofessential goods have increased many fold.This asymmetry in the price behaviormakes the problem complex and it createsdistortions in the economy by makingdistribution of factors non-optimal.In a symposium sponsored by theCommittee for Economic Development onthe theme "What is the most importanteconomic problem to be faced by the UnitedStates in the next twenty years?" in 1958Professor Samuelson commented that thethreat being asked is nothing but inflation.In an explanatory vein, he further observed:

"The history of the twentieth century …… hasbeen pretty much a history of rising prices...inflation is itself a problem. But the legitimateand hysterical fears of inflation are - quite aside from the evil of inflation itself - likely, in their own right, to be problems. In short, I fear inflation. And I fear the fear of inflation. Avoiding inflation is not an absoluteimperative, but rather is one of a number of conflicting goals that we must pursue and thatwe may often have to compromise. Even if themilitary outlook were serene - and it is not -

modern

democracies must expect in the futureto be much of the time at, or near, the pointwhere inflation is a concern. Our greatesteconomic problem will be to face that concernrealistically, to weigh inflation's quantitativeevil against the evils of actions taken against it,to develop methods of adjusting to the residue of inflation which attainment of the 'golden mean'might involve. The challenge is great but the prognosis is cheerful."

[From

Nobel Lectures , Economics 1969-1980

,Editor Assar Lindbeck, World ScientificPublishing Co., Singapore, 1992 ]

What Professor Samuelson said in theperspective of American economy is alsotrue for other regions of the worldincluding India. If we compare theexperience of Indian price levels with thesame in the 1970s, we find that pricemovements had become much morecomplex in the 1970s. And the followingdecades has been a mad race among moneysupply, prices and money incomes that hadleft a section of society marginalized andmuch worse off. This is the distributioneffect of inflation and for this, inflation is amacro phenomenon-much hated, but alsodebated in the literature.Inflation is what is explained in the aboveparagraphs. Considering its importance,economists have suggested two approachesto address this issue:(i)Economic policies targeting zeroinflation, and(ii)Economic policies targeting amoderate rate of inflation.Coming to (ii) first some economists arguethat a moderate rate of inflation, say 3 percent is good for the economy, as that helpsin the efficient choice of factor combinationin face of downward rigidity of factorprices ( Svensson, 1997 ).Thus, a literature on inflation targeting hasdeveloped and theoretical framework hasbeen analyzed to compare inflationtargeting with targeting of real exchangerate.At present, twenty-two countries in theworld are practicing inflation targeting andwith different objectives (Table 1). But whileinflation targeting is common, there aredifferences among these countriesregarding the emphasis and accordinglymonetary and fiscal policies are formulated.

TABLE 1Countries having objectives as inflation targeting: 2007

Australia (H)Brazil (P)Canada ( M)Chile (C)Colombia (H)Czech Republic (H)Finland (C)Hungary (H)Iceland (H)Israel ( M)S. Korea( H) Mexico (P)New Zealand (P)Norway (H)Peru (P)Philippines (H)Poland (H)South Africa (P)Spain (H) Sweden ( P)Thailand (H)United Kingdom (H)

Source: Truman ( 2007 ), Page 29.Notes:: Meaning of the alphabets within the parentheses are the following:C



Currency stability as principal objectiveH



Hierarchy with price stability firstM



Multiple objectives and no hierarchyP



Price stability as sole objective

Inflation Targeting and Optimal Level of it- Sukumar Nandi

There are at least two problems regarding inflation targeting. First, price stability is oneprimary objective of the central bank of the country. With that objective in view, centralbank keeps a target inflation rate in view that may or may not come in public domain.To attain this objective, it depends on two important parameters of macroeconomics –the expected growth rate of gross domestic product ( RGDP) and the income elasticity ofcash balance ( IECB). Since the Quantity Theory of Money (QTM) explains that inflationis largely determined by the differential of two growth rates – the RGDP and the growthrate of money supply (RMS). If the central bank has the idea of IECB from historicaldata, money supply is controlled in such a way that it takes care of the target inflationrate given the estimate of the differential (RMS – RGDP).But since inflation is a continuous process, it enters into the expectation of theindividuals while they adjust their demand for cash balance as the trade off is theinterest foregone for maintaining sufficient liquidity. Thus, the estimate of IECB maychange over time and that may create problem for the central bank.Let us now consider (i) , or the target of zero inflation rate. Since inflation has manynegative influences on the economy and keeping a moderate inflation target issometimes difficult, some economists support the view that zero inflation should be thetarget (Poole, 1999).But target of zero inflation creates problem for effective functioning of monetary policieswhen the economy is afflicted with business cycles. Because of the Fisher Equation(Fisher, 1930) money interest is the sum of real interest rate and expected inflation rate

. If the economy is in the downswing, the central bank comes under pressure to reduceinterest rate and any significant reduction of interest rate in face of zero inflation ratetargeting may drastically reduce the real interest rate and it may even become negative.The monetary policy of the central bank is reflected in the pattern of growth of themoney stock and not the movement of the interest rate. The primary duty of the centralbank is to provide optimum liquidity in the economy and in that pursuit it controls themoney stock given the projected figure of the gross domestic product. In this perspectivethe question of optimum rate of inflation is important and skeptics raise the questionwhether it is functionally possible for a central bank to follow a uniform rate of inflationas a target. Rather is it not natural that in the process an inflationary expectationbecomes built-in into the system and then inflation in real form becomes evident? Thishas been the experience in many countries.

Irving Fisher used to interpret his famous equation as the nominal interest should adjust to the changes in the inflationrate with some lags and the equation explain how interest rate would behave in a world with people having ‘foresight’ ,which in modern interpretation may be termed as ‘rational expectation’.

Metamorphosis Vol. 7 No.1, 2008