Inflation targeting

Question 1

Generally, why 2%?

Answer 1

2% is low enough that it is not detrimental to the economy, while also being far enough away from the ZLB so that recovery from a recession can occur. A target that is trusted by the population also means that inflation expectations are anchored, leading to price stability.

Question 2

What is a flexible inflation target?

Answer 2

CBs also consider output fluctuations caused by their changes, meaning that the CB doesn’t respond to all fluctuations from the target. Targeting is therefore a medium/long term goal to minimise the costs of continuous fluctuations

Question 3

What is the Short run Fisher equation?

Answer 3

i = r + inflation expectation

Question 4

What are inflation expectations in the SR and what effect does this have on the fisher equation?

Answer 4

Due to price rigidity, inflation expectations are constant. If this expectation is equal to the target, then expectations are anchored. Therefore, lowering i (nominal rate) will lead to a reduction in the real interest rate (r), leading to more investment, spending, and production (economic growth).

Question 5

What is the neutral (natural) real interest rate?

Answer 5

Real policy interest rate consistent with full employment, zero output gap, and stable inflation.

Question 6

What is an expansionary real interest rate relative to the natural interest rate?

Answer 6

r<r* is expansionary

Question 7

Explain the ZLB fear in the SR

Answer 7

With inflation expectations constant, the level of that inflation determines how low r is when i = 0. Therefore, when inflation is too low, there is less room to change i, in order to manipulate r to trigger an economic recovery.

Question 8

Explain the ZLB fear in the LR

Answer 8

With r* constant, there is a direct relationship between inflation expectations and the nominal rate. Therefore if there is a need to lower i when at r*, the inflation level determines how much change can happen.

Question 9

Give 6 reasons why deflation is not the target, despite OLG model suggesting its optimal

Answer 9

1) Deflation associated with weakness
2) System evolved to accumulate for it (long term contracts written with the assumption.
3) Debt-deflation (raises costs of paying debt)
4) Tax rates not indexed to prices
5)Downward wage rigidity (hard for firms to meet costs)
6) Fear of ZLB

Question 10

Why is it important that an expectation anchor doesn’t break?

Answer 10

expectations of high inflation can become self-fulfilling

Question 11

What is capital of inattention?

Answer 11

With low inflation in the 2010s agents stopped paying attention to inflation, anchoring them at a very low level.

Question 12

Give 3 structural factors for low inflation in the 2010s

Answer 12

1) Globalisation
- Limited inflation in traded goods
- International supply chains -> lower costs

2) Automation
- Higher wages not passed on

3) Dominance of market share by companies with high profit margin.
- Could absorb higher costs

Question 13

How did the GFC cause low inflation in 2010s?

Answer 13

• Weak global demand
• Risk aversion
• Sluggish recovery

Question 14

2 Ways CBs responded to GFC

Answer 14

1) Lowered interest rate near 0
2) Used QE to stimulate further

Question 15

Why didn’t QE following GFC cause inflation?

Answer 15

Increase in CB money did not translate into increased money spending or commercial bank money

Question 16

What happened to the Phillips curve after GFC

Answer 16

Became flatter (Changes to unemployment didn’t have big impact on inflation) Caused by very low and well-anchored inflation expectations.

Question 17

How is the LR Fisher equation different to SR?

Answer 17

In long run, policy real interest rate is r*, meaning there is a direct relationship between the inflation target and the neutral nominal interest rate. This means that if a shock causes inflation to fall below target, expansion by lowering nominal rate can only occur if the target is large enough