5- Inflation targeting Flashcards
What happens when the Bank of England misses inflation target by +/-1%?
They must write a letter to the government explaining why they’ve missed the target and what’s being done to correct
Outline 3 main reasons central banks don’t want deflation
-Lost tax revenue
-Downward wage rigidity
-Avoiding the ZLB
Why does deflation lose the government tax revenue?
For example the same rate of VAT will generate less tax if a good falls from $100 to $90
What are 2 main reasons prices are sticky in the short-run?
-Time dependent price setting: firms decide to adjust prices at given periodic intervals
-State dependent price setting: firms make measured assessments of appropriate prices given economic conditions (this is intensive and cannot be continuous)
Why is downward wage rigidity problematic for deflation?
Deflation means salary contracts become more expensive so firms may be forced to reduce nominal wages
What is the short-run Fisher equation?
Nominal interest rate = Real interest rate + Inflation expectations
i = r + πᵉ
What does short-run price rigidity mean for inflation expectations (πᵉ)?
Inflation expectations can be seen as a constant in the short-run
What do constant inflation expectations mean for interest rate policy?
Changes in the nominal rate have a direct impact on the real interest rate which is how saving and investment can be manipulated to control the economy
What is the neutral rate (r*)?
The real policy interest rate consistent with full employment, zero output gap and stable inflation
When are central banks taking monetary policy stances?
When the nominal rate (i) is set such that:
r < r* (expansionary) or
r > r* (contractionary)
Why does the Zero Lower Bound (ZLB) mean central banks want to avoid deflation?
Central banks can only cut nominal rates (i) to zero, if inflation target is too low, the extent to which central banks can cut real rates (r) to stimulate the economy is limited
What happens to the real interest rate in the long-run?
The obsoletion of cyclicality in the long-run means the real interest rate is constant and independent of monetary policy r = r* = r̄
What does a constant real interest rate (r̄) in the long-run mean for the neutral nominal rate (i*)?
In the long-run there is a direct relationship between the inflation target (πᵀ) and the neutral nominal rate (i*) such that it determines how far above the ZLB policy rate will be in neutral state
Outline the basic reasoning behind the 2% inflation target?
Low enough that inflation at this level is not detrimental to the economy. Far enough away from ZLB that monetary policy has room to cut rates if needs to stimulate economic activity
What fundamentally drives the neutral real rate (r*)?
Structural supply and demand for money i.e. higher propensity to save (supply↑) or lower propensity to invest (demand ↓) makes money cheaper (r*↓)
Outline 3 main determinants of the neutral rate (r*)
-Economy’s potential growth rate
-Demographic trends
-Risk appetite
How does the economy’s potential growth rate affect r*?
-Weaker growth lowers the marginal return on capital, decreasing investment.
-Weaker growth lowers expected incomes so households save more in response
How do demographic trends affect r*?
-Higher share of working age population leads to more saving
-Increasing life expectancy means people have to save more for a longer retirement
How does risk aversion affect r*?
Higher risk aversion increases savings and reduces investments which have uncertain returns
How does the target control inflation expectations?
The target serves as a nominal anchor, it is a number easily understood by the public who trust the central bank will do what it takes to achieve it
What do anchored inflation expectations look like in practice?
-Price and wage setting consistent with target
-Long term contracts assume target inflation
Why do well anchored expectations help achieve monetary policy goals?
If there’s an exogenous inflationary shock, well anchored expectations mean agents will continue
behaving according to the target and won’t exacerbate it through distortionary behaviour
Briefly outline why central banks were slow to respond to inflation in 2021
Assumed transitory inflation and well anchored expectations when actually they were below target
What are the consequences of de-anchored inflation expectations?
-Behaviour makes inflation self fulfilling by higher expectations for contracts etc
-Economically costly to reconvince people central bank will do what it takes to achieve target
Outline the ‘Capital of Inattention’ towards inflation in the 2010s
Consistently low inflation meant agents became used to it and adjusted behaviour accordingly e.g. index linked loans became largely obsolete
Describe the main structural supply-side reason for low inflation in the 2010s
Globalisation meant competitive international markets limited inflation in traded goods and labour intensive factor inputs could be outsourced to cheaper countries
What were the 2 main demand-side reasons for low inflation in the 2010s?
-Sluggish recovery meant low demand
-GFC scarring led to risk aversion amongst lenders and borrowers
How did central banks respond to the great recession?
Lowered policy rates to near zero and had to implement QE to further stimulate
What is the main reason QE did not cause inflation post-GFC?
Central banks increased liquidity through the banking sector via reserves, this didn’t increase lending because of heightened risk aversion so wasn’t translated into broad money
Why is changing the inflation target problematic?
Changing the target jeopardises credibility so a very convincing reason is required to avoid de anchoring expectations
What is Flexible Average Inflation Targeting (FAIT)?
Seeking inflation that averages the target over an unspecified time frame
What is the main benefit of FAIT?
If credible, inflation expectations stay at target even if there are under/overshoots because policy will ensure there is a compensating effect over the long run
