The inflation fighting trade-off

Note: Other posts in this discussion are available under the tag “inflation debate“.

So, after calling on you guys to give me some indication of your views on monetary policy we discussed what inflation is, and then we moved on to discussing the costs that stem from inflation. We are now ready to discuss the big topic – the trade-off between inflation and other things.

I’m glad that we managed to talk about this topic this year, as it is the 50th anniversery of the paper “the Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957” written by our own Dr Phillips. In this paper Dr Phillips found that, over this period, there was a negative relationship between money wage changes and unemployment.

This was eventually broadened to a negative relationship between inflation and unemployement, which gave rise to the Phillips curve. Initially this led economists to believe that there is a trade-off between inflation and unemployment. However, the instability of the Phillips curve when policy analysts tried to take advantage of this relationship (when analysts tried to use the relationship it disappeared), and the popularity of the natural rate hypothesis (stating that there is a “natural rate” that unemployment settles at), led to a movement away from this, and the statement that there is no long-run trade-off between inflation and unemployment! (now viewed as the NAIRU)

Taking this as given, what other trade-offs are there?

Trade-off between inflation and output

Now the fact that we have accepted no long-run trade-off between inflation and unemployment does not imply that there is no trade-off between inflation and output. After all, even if unemployment keeps settling back at a certain level how can we be sure that the capital/labour ratio will be the same.

As a result there are two main channels that inflation can effect long-term output through – the real interest rate and uncertainty.

The general belief is that there is no long-run inflation-output trade-off, this presumes that money is “super-neutral” over the long run. Yet there are counter-arguments.

There is a school of thought that states that (moderate) levels of inflation are actually good for long-term growth, as in sticky-price models they tend to reduce the steady state (long-run) level of the real interest rate.

However, I’m not quite sure how much I buy this. In the long-run all prices can adjust – so why is the relative price of money now lower?

There is another school of thought who believe that inflation creates uncertainty, uncertainty reduces investment intentions, and so inflation reduces long-run growth.

However, as we will discuss later, it may be the case that attacking inflation increase uncertainty (by making output variable) – which would retard investment (Note: This channel would include the impact of exchange rate volatility – if you were wondering where that fit in 😉 ).

Now overall there is no strict consensus on the long-run inflation level output level trade-off, however since both issues seem equally irritating, and the estimated long-run trade-off is often indeterminant and small, economists often settle for the middle road assumption of no trade-off.

Welfare and the persistence of inflation

Now the goal of any policy is not to maximise output, or even growth, it is to maximise the welfare of society.

To start with, we can tell that if there was no long-run trade-off between inflation and output, and if there was no cost to inflation (which is false) then governments would want to keep using the short-run trade-off to boost output – as there is a short-term benefit to doing so.

However, as inflation has a welfare cost this is not likely to be the best policy.

Think of it this way. A higher rate of inflation is more costly for perpetuity – as inflation is persistent (thanks to inflation expectations). Reducing inflation is costly for 1 period, while increasing inflation is beneficial for one period. As a result, the level of inflation now has a “long-run cost” if that is where we leave it, while adjusting the level of inflation only provides a “short-term” benefit/cost.

In this sense, we will want to have a lower level of inflation/tighter monetary policy than will appear to be optimal during a single period – as the cost of inflation now “spills over” into other periods of time (accepting inflation now will put a negative externality on future generations).

The trade-off between inflation and output variability

However, it is not only inflation hawks who can appeal to welfare as a defense for their point of view.

Many of the costs of inflation stem from unnecessary variability in prices. Yet trying to prevent large swings in the price level may lead to unnecessary variability in the level of output.

Variable output is costly because people lose their jobs (or gain jobs that they will not be able to keep for long). Furthermore, it will also distort the incentive to invest by creating uncertainty.

If we face a demand shock, the goals of fighting inflation and keeping output levels stable are actually the same thing – so its all good.

If we face a supply shock (such as drought or an increase in petrol prices) then we face a trade-off between price and output volatility.

However, the important thing to remember here is that the trade-off between output and price volatility is a short-medium term trade-off; the persistence of inflation that was discussed earlier still remains.

Conclusion

We have covered a large number of the trade-off’s associated with the Central Bank attacking inflation here. If you have any more trade-off’s in your head, please add them in the comments 🙂

Overall, there seems to be a bunch of pluses and minuses, and no way to sort our way through them.

The next post will discuss how inflation targeting tries to deal with these trade-offs. From there we will move on to discussing other ways of coping with these trade-offs.