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Inflation Targeting and Optimal Level of It

Inflation Targeting and Optimal Level of It

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Published by: sukumarnandi@hotmail.com on Oct 04, 2008
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06/16/2009

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Targeting an Optimal Level of Inflation: A Theoretical PerspectiveSukumar NandiIndian Institute of Management LucknowLucknow – 226013, India
In a macroeconomics class one student asked , What is inflation? Before answering thequestion I took a little pause and then gave the text book answer. The student was notsatisfied 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 difficulttask, though to make survey of prices of commodities over time is conceptually easy. Butwhen 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 noisemay be seasonal pattern, resource shocks, exchange rate changes, or asymmetric priceadjustments. 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 thatcentral bank’s particular target of inflation and the monetary policy attuned to that targetmay be influenced by that bias ( Shapiro and Wilcox, 1998).The monetarist theory of inflation explaining that more than optimum amount of supplyof money will induce demand expansion and that additional demand will be liquidated byan overall increase in prices of commodities. This demand-pull inflation has the problem1
 
that all commodities may not get price hike and also the price increase may not be at thesame rate.In 1960s economists discovered that inflation may be possible even without increase inmoney supply and they came with the idea of cost-push inflation. But how cost escalationstarts 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 thatreal 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 bymaking 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 thenext twenty years?" in 1958 Professor Samuelson commented that the threat beingasked 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 asidefrom 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 oneof 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 thefuture to be much of the time at, or near, the point where inflation is a concern. Our greatesteconomic problem will be to face that concern realistically, to weigh inflation's quantitative evilagainst 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 ]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 pricelevels with the same in the 1970 s we find that price movements had become much morecomplex in the 1970s. And the following decades has been a mad race among moneysupply, prices and money incomes that had left a section of society marginalized andmuch worse off. This is the distribution effects of inflation and for this inflation is amacro phenomenon much hated but also debated in the literature.Inflation is what is explained in the above paragraphs. Considering its importanceeconomists 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 inface of downward rigidity of factor prices ( Svensson, 1997 ).Thus a literature on inflation targeting has developed and theoretical framework has beenanalyzed to compare inflation targeting with targeting of real exchange rate.At present twenty-two countries in the world are practicing inflation targeting and withdifferent objectives (Table 1). But while inflation targeting is common, there aredifferences among these countries regarding the emphasis and accordingly monetary andfiscal policies are formulated.Table 1: Countries having objectives as inflation targeting: 2007Australia (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

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