On Inflation Targeting

The rate of Inflation is of great concern to the Central Bank of a country as well as to its Government.

This concern of the authorities is what makes ‘inflation targeting’ important. But should it be the only concern?

What is ‘Inflation targeting’?

Inflation targeting is a framework for operating monetary policy. The first authority to formulate it was the Reserve Bank of New Zealand in the early 1990s. It is undertaken by the monetary authorities and it tries to keep the price stable without adversely affecting output and employment. [Khatkhate 2006]

On Phillips curve

The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Although several people had made similar observations before him, A. W. H. Phillips published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. [Hoover]

Inflation targeting has gained a lot of importance, mainly owing to the downward slope of the Phillips curve.

On NAIRU

NAIRU or Non-accelerating inflation rate of unemployment was introduced by Milton Friedman and Edmund Phelps during the 1970s.

NAIRU is a steady state unemployment rate above which inflation would fall and below which inflation would rise.

The natural rate of unemployment is a key concept in modern macroeconomics. Its use originated with Milton Friedman’s 1968 Presidential Address to the American Economic Association in which he argued that there is no long-run trade-off between inflation and unemployment: As the economy adjusts to any average rate of inflation, unemployment returns to its “natural” rate. Higher inflation brings no benefit in terms of lower average unemployment, nor does lower inflation involve any cost in terms of higher average unemployment. A second important unemployment rate is the “Non-Accelerating Inflation Rate of Unemployment,” or NAIRU. This is the unemployment rate consistent with maintaining stable inflation. According to the standard macroeconomic theory enshrined in most undergraduate textbooks, inflation will tend to rise if the unemployment rate falls below the natural rate. Conversely, when the unemployment rate rises above the natural rate, inflation tends to fall. Thus, the natural rate and the NAIRU are often viewed as two names for the same thing, providing an important benchmark for gauging the state of the business cycle, the outlook for future inflation, and the appropriate stance of monetary policy. [FRBSF Economic Letter 1998]

A digression

I am digressing from ‘inflation targeting’ and am going to talk about a welcome proposal by the Indian Government.

In a bid to obtain a `true picture’ of the effect of price changes on the economy, the Union Finance Ministry has proposed the inclusion of services in the Wholesale Price Index (WPI) which is used to measure point-to-point inflation. In India, the services sector accounted for 54 per cent of the GDP during the previous fiscal year. [The Hindu 2007]

In an earlier post of mine, I had argued for a restructuring of the WPI.

Conclusion

Giving too much significance to the ‘Inflation rate’ without adequate and corresponding developments in food supply, public distribution systems, etc will not help combat the problems of unemployment. Thus the fiscal and monetary authorities must ensure that such areas are targeted during a ‘rise in inflation’.

Increasing interest rates and importing food grains so as to bring down inflation rates will not succeed as the ‘inflation’ is basically caused by distributional inefficiencies.

References

1) Deena Khatkhate, Inflation Targeting, Dec 9 2006, EPW.

2) Kevin D. Hoover, The Concise Encyclopedia of Economics.

      3) Federal Reserve Bank of San Francisco, The Natural Rate, NAIRU, and Monetary Policy, 1998.

Further Reading

1) The Phillips curve by Bradford DeLong.

2) The NAIRU by Bradford DeLong.

3) History and Theory of the NAIRU: A Critical Review by Espinosa and Russell.

      4) Why inflation still matters, Frontline, Jayati Ghosh, 2006.

14 thoughts on “On Inflation Targeting”

  1. Even though the Phillips curve suggests a negative relationship between Unemployment and Inflation, the reality is very different for many countries (example Stagflation). Inflation also can lead to hyperinflation which is a huge problem in itself. Most level-headed economists agree that macroeconomic problems don’t arise due to a single variable. Keynesian’s look at inadequate demand, Monetarists attribute money supply, supply-siders supply creating its own demand etc. So what should the Fed target? The experience of most Feds in the recent times(last 15 years) has been price of money(interest rates) and inflation. Some have succeeded and yet some are struggling. Also, newer theories have to account for the impact of Globalization and the tremendous increase in cheap labor(India and China). The important thing to consider is that each economy is different in nature and a differential diagnosis is required to solve their individual macroeconomic problems.

  2. Mohit,

    “The important thing to consider is that each economy is different in nature and a differential diagnosis is required to solve their individual macroeconomic problems.”

    I concur with you completely; as all economies have different characteristics and the relative importance of variables will change from country to country. When considering, it is important to study social, political, cultural and economic variables pertaining to the economy.

    Riot,

    Low population growth is certainly one of the variables associated with economic development. I feel that the relative importance of low negative growth [towards economic development] is not much if there are proper and efficient public service systems in place. What do you think?

  3. With population, the thing which is quite important is its structure.

    Population growth shows its productive impact 2 decades later when the working age-group’s share in the total rises. Taking an example from the real world, it is argued that India have a benefit over China in the long run because the low rate of population growth in China will increase dependent population 20-30 years hence. Hence, India will be more productive later on, on this basis.

    So, low rate of population growth is not necessary for economic development. In fact, Simon Kuznets strictly emphasised the high population growth characteristic of Modern Economic Growth in the European Nations in the 19th century.

  4. I have to disagree with Ashish Tyagi here. In fact, I disagree with a lot of economists who do not understand the finity of earth’s resources. I am more interested in quality of life. Here is an article written by George Monbiot a while back

    http://www.monbiot.com/archives/2002/12/31/deliver-us-from-finity/

    “With the turning of every year, we expect our lives to improve. As long as the economy continues to grow, we imagine, the world will become a more congenial place in which to live. There is no basis for this belief. If we take into account such factors as pollution and the depletion of natural capital, we see that the quality of life peaked in the United Kingdom in 1974 and in the United States in 1968, and has been falling ever since. We are going backwards.”

  5. Ashish,

    You are taking about the ‘Demographic Dividend’ which i have mentioned here.

    Riot,

    It is true that with more pressure on the land from increased population, resources are depleting at a faster rate than before. Limiting the usage of resources is necessary for sustainable development.

  6. Alex,

    Absolutely. Must say that the post was quite illuminating.

    Riot,

    I agree with you on the issue of sustainable development. I just wanted to highlight the point that there are historical evidences to suggest that high population growth have facilitated economic development. Clearly, natural resources have become scarcer since then & this issue should also be heeded.

    This makes the challenge in front of developing nations even more difficult to achieve.

  7. Alex,
    hv been reading ur Blog.Very comprehensive articles, I must say.Your crisp Analysis makes it easier for general people like me to have a better undestanding of Economic matters.

    There was an article About ‘China’s Inflation cotrol’ on last weeks BusinessWorld magazine.
    I am giving the link here.Would love to get ur perspective on it and on Jahangir Pocha’s (BW reporter) take on the matter.I actually found his arguments to be a bit softer on the analytical fronts. I may be wrong.What do u think?
    Regards.

    [LINK]

  8. I haven’t read through all the comments. But the Phillips curve relationship between inflation and unemployment is misleading. The ACTUAL relationship is between unanticipated inflation and cyclical unemployment. This equation is given by (Inflation) = (Expected Inflation) – (parameter measuring cyclical unemployments sensitivity to inflation)x(unemployment rate – natural rate of unemployment)

    SO: π = eπ – α( u-u̅ ) where eπ stands for expected inflation and u̅ stands for the natural rate of unemployment.

  9. terms are quiet strange for me , alex try to add a dictiOnary link[economics ]IN A CORNER.
    i coudnt understand that u WERE described about population , and while I AM reading ur article , i happend to met about ‘WAGE ‘
    and iam leaving new link with this ,hope it will useful for u , its with KARL MAX ,TRY TO CONNECT THIS WITH UR POPULATION AND INFLATION, LETS HAVE A MINOR DISCUSSION ..OK,NO DESECTIONS .

    http://www.marxists.org/archive/marx/works/1847/wage-labour/ch09.htm

    BEST,,,

  10. Naquash,

    I dont think it is necessary to add a dictionary of economics as any jargon can be freely researched on the internet.

    Hufrish,

    Incidentally, perfect competition happens to be a part of my next post.

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