Targeting an Optimal Level of Inflation: A Theoretical Perspective

Sukumar Nandi

Indian Institute of Management Lucknow

Lucknow – 226013, India

In a macroeconomics class one student asked , What is inflation? Before answering the
question I took a little pause and then gave the text book answer. The student was not
satisfied and that was along the line of my expectation and that is why I took a pause.
Even today it is difficult to convince a student of a different discipline about the nature of
inflation. The reasons are not difficult to understand. Measuring inflation is a difficult
task, though to make survey of prices of commodities over time is conceptually easy. But
when that information is used to make some index, problems emerge from two sources.
First, price movements may be a transitory phenomenon, or noise. Sources of such noise
may be seasonal pattern, resource shocks, exchange rate changes, or asymmetric price
adjustments. But noise should not affect policy makers’ actions.
The second problem comes out of biases that are consequences of weighting pattern,
sampling technique or quality adjustment used for price calculations. The problems of
biases is much more important compared to the existence of noises in the sense that
central bank’s particular target of inflation and the monetary policy attuned to that target
may be influenced by that bias ( Shapiro and Wilcox, 1998).

The monetarist theory of inflation explaining that more than optimum amount of supply
of money will induce demand expansion and that additional demand will be liquidated by
an overall increase in prices of commodities. This demand-pull inflation has the problem

1
that all commodities may not get price hike and also the price increase may not be at the
same rate.
In 1960s economists discovered that inflation may be possible even without increase in
money supply and they came with the idea of cost-push inflation. But how cost escalation
starts leading to price rise remains a naughty question.
If we collect data for a long list of commodities for the last twenty years we will see that
real prices of many commodities have gone down (electronics and many consumer
goods), while prices of essential goods have increased many fold. This asymmetry in the
price behavior makes the problem complex and it creates distortions in the economy by
making distribution of factors non-optimal.

In a symposium sponsored by the Committee for Economic Development on the theme

"What is the most important economic problem to be faced by the United States in the
next twenty years?" in 1958 Professor Samuelson commented that the threat being
asked is nothing but inflation. In an explanatory vein he further observed:

"The history of the twentieth century …… has been pretty much a history of rising prices...
inflation is itself a problem. But the legitimate and 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 absolute imperative, but rather is one
of a number of conflicting goals that we must pursue and that we may often have to compromise.
Even if the military outlook were serene - and it is not - modern democracies must expect in the
future to be much of the time at, or near, the point where inflation is a concern. Our greatest
economic problem will be to face that concern realistically, to weigh inflation's quantitative evil
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 Scientific
Publishing Co., Singapore, 1992 ]

2
What Professor Samuelson said in the perspective of American economy is also true for
other regions of the world including India. If we compare the experience of Indian price
levels with the same in the 1970 s we find that price movements had become much more
complex in the 1970s. And the following decades has been a mad race among money
supply, prices and money incomes that had left a section of society marginalized and
much worse off. This is the distribution effects of inflation and for this inflation is a
macro phenomenon much hated but also debated in the literature.
Inflation is what is explained in the above paragraphs. Considering its importance
economists have suggested two approaches to address this issue:
(i) Economic policies targeting zero inflation, and
(ii) Economic policies targeting a moderate rate of inflation.

Coming to (ii) first some economists argue that a moderate rate of inflation, say 3 per
cent is good for the economy as that helps in the efficient choice of factor combination in
face of downward rigidity of factor prices ( Svensson, 1997 ).
Thus a literature on inflation targeting has developed and theoretical framework has been
analyzed to compare inflation targeting with targeting of real exchange rate.

At present twenty-two countries in the world are practicing inflation targeting and with
different objectives (Table 1). But while inflation targeting is common, there are
differences among these countries regarding the emphasis and accordingly monetary and
fiscal policies are formulated.

Table 1: Countries having objectives as inflation targeting: 2007

Australia (H) Brazil (P) Canada ( M) Chili (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)

3
Source: Truman ( 2007 ), Page 29.
Notes:: Meaning of the alphabets within the parentheses are the following:
C  Currency stability as principal objective
H  Hierarchy with price stability first
M  Multiple objectives and no hierarchy
P  Price stability as sole objective

There are at least two problems regarding inflation targeting. First, price stability is one
primary objective of the central bank of the country. With that objective in view central
bank 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 of
cash balance ( IECB). Since the Quantity Theory of Money (QTM) explains that inflation
is largely determined by the differential of two growth rates – the RGDP and the growth
rate of money supply ( RMS). If the central bank has the idea of IECB from historical
data, money supply is controlled in such a way that it takes care of the target inflation rate
given the estimate of the differential ( RMS – RGDP ).
But since inflation is a continuous process, it enters into the expectation of the individuals
while they adjust their demand for cash balance as the trade off is the interest foregone
for maintaining sufficient liquidity. Thus the estimate of IECB may change 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 many
negative influences on the economy and keeping a moderate inflation target is sometimes
difficult, some economists support the view that zero inflation should be the target
( William Poole, 1999).
But target of zero inflation create problem for effective functioning of monetary policies
when 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 rate1.

1
Irving Fisher used to interprete his famous equation as the nominal interest should adjust to the changes in
the inflation rate 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’.

4
If the economy is in the downswing, the central bank comes under pressure to reduce
interest rate and any significant reduction of interest rate in face of zero inflation rate
targeting may drastically reduce the real interest rate and it may even negative.

The monetary policy of the central bank is reflected in the pattern of growth of the money
stock and not the movement of the interest rate. The primary duty of the central bank is to
provide optimum liquidity in the economy and in that pursuit it controls the money stock
given the projected figure of the gross domestic product. In this perspective the question
of optimum rate of inflation is important and skeptics raise the question whether it is
functionally possible for a central bank to follow a uniform rate of inflation as a target.
Rather is it not natural that in the process an inflationary expectation becomes built-in
into the system and then inflation in real form becomes evident? This has been the
experience in many countries.

References:

Fisher, Irving, The Theory of Interest, London, Macmillan, 1930

Poole, William, Is Inflation too Low?, Federal Reserve Bank of St. Louis Review, July –
August , 1999, pp 3 – 10 .

Shapiro, Matthew D. and David W. Wilcox, Bias in the Consumer Price Index, NBER
Macroeconomics Annual, B. Barnanke and J. Rotenburg (eds), MIT Press, 1998

Svensson, Lars E. O., Optimal Inflation Targets, ‘Conservative’ Central Bank, and Linear
Inflation Contracts, American Economic Review, March, 1997, pp 98 – 114 .

Truman, Edwin, Inflation Targeting in World Economy, Institute of International

Economics, 2007

5
6