Inflation targeting failure: Why inflation targeting?

Article from Dom Post on Saturday is here (*).

Other New Zealanders discussing inflation targeting can be found here (*) and here (*).

In order to make justify the defense of inflation targeting let me note down a few points about why inflation targeting is used and how it should work.

Inflation targeting is …

Inflation targeting is when the Central Bank sets an inflation target – seems simple enough.

However, the effectiveness of inflation targeting as a mechanism stems from the Bank’s “credibility”. Fundamanetally, if the price setters in society (that includes wage earners) believe that the Bank will act to stop general increases in the price level then they will factor this in when they go to set their own prices – which will, in itself. reduce growth in the general price level.

We like to target inflation because, if we have a fully credible central bank we can keep inflation low, but react to sudden sharp shocks to economic activity. As a result, we get the benefit of low inflation, and the potential for economic stabilisation from monetary policy – the very endevour that the US is trying to pull off at the moment!

It’s all about the money supply – why don’t we just set that at the right level?

The sole mandate Central Bank concept stemmed from the monetarist school. In this view, inflationary (deflationary episodes stem from errors by the Bank, specifically the printing of excess (too little) money given money demand (which is a function of output growth). Fundamentally, this provides a supply-demand view of money with nominal interest rates as the price (quantity theory).

Given this alone an obsession with inflation expectations may seem weird – after all “Inflation is always and everywhere a monetary phenomenon” (quote from Milton Friedman).

The obsession with inflation expectations stems from New Keynesian economics (such as Greg Mankiw). New Keynesian economics accepts the rational expectations hypothesis of the New Classicals, but they expand upon this by introducing nominal rigidities to the economy (eg sticky prices). With rational expectations, people may see that the Bank will try to inflate its way towards higher growth – and agents will set higher prices.

This view does not seem inconsistent with monetarism in any sense. As a result it raises the question, why don’t we just target the money supply? Also, why do New Keynesians care so much about inflation expectations?

Setting the money supply.

Part of the answer to the first question is that we can’t effectively target the quantity of money in the economy. Given the range of financial institutions in the economy money supply can be difficult to measure, and the ability of the Central Bank to change the money supply is uncertain. Remember, the supply of money is not just the result of how much the Bank prints, but also the amount of leverage financial institutions can get, and how much credit they can create.

Furthermore, even if we can figure out what is going on with money supply we don’t just want it to be constant – we want it to increase with output levels in the economy. Money is the oil in the joints of the economy – as it allows us to trade with relatively low transaction costs. Given nominal rigidities in the economy we know that it would be best if the general price level did not change, as it would allow relative prices to be set quickly and would improve allocative efficiency. The more activity we have in the economy, the more money we require to satisfy these transactions.

Now, we struggle to measure GDP in the economy, let alone actual activity and productivity growth. The measures we get are often highly revised and are also relatively historical (March GDP numbers aren’t out till June – and they will probably we revised a few times over the next 4 years). In this sense, there is alot of uncertainty inherent with a quantity target.

Economists have another variable they can set other than the quantity – they set a price. As the nominal interest rate behaves as the “price” on money (fundamentally because money demand is downward sloping in the nominal interest rate). Assuming that the money supply is not influenced by the interest rate (which is a big assumption) this method allows us to get a feeling for the money demand curve (by shifting interest rates around a little), and is also easier to adjust than the quantity of money.

In essence though, setting an interest rate and setting the “supply of money” are two sides of the same coin – if we think that the Bank should keep greater contol of the money supply we are effectively saying we want higher interest rates!

New Keynesians and inflation expectations

We have come so far but we still haven’t discussed inflation expectations. The degree of disagreement between New Keynesians and Monetarists is also very small here – and lies specifically with something called the Velocity of money.

Going back to the quantity theory of money we know that Money*velocity=prices*real output must hold. Now if people believe that there will be a greater amount of inflation they will set higher prices independent of the amount of money in the economy – forcing the velocity of money to increase. If the velocity of money can increase around the economy (which seems believable especially in the electronic age) then this higher price level can be reached even without any change in the amount of money in the economy.

Monetarist generally say that velocity must be stable (which is why they can focus so exclusively on the quantity of money) while New Keynesians are of the view that velocity can vary, especially when some type of inflationary expectations enter the economy.

I am more in the second camp (although I accept that the velocity issue has a lot of interesting components) – which explains my concern at rising inflation expectations in New Zealand.

Update:  I forgot to mention that another way of looking at inflation expectations is as an increase in money demand.  If we only set a “price” for money and not a quantity, then rising inflation expectations will increase the demand for money and thereby increase the quantity.  As a result, we need to be vigilant in the case of rising inflation expectations, because under the current framework that will directly lead to inflation.

10 replies
  1. Don Lloyd
    Don Lloyd says:

    …The more activity we have in the economy, the more money we require to satisfy these transactions.

    Nonsense. Every transaction that involves money places no stress on the supply of money, but merely transfers the ownership of the money purchase price from the buyer to the seller.

    …Fundamentally, this provides a supply-demand view of money with nominal interest rates as the price (quantity theory).

    Not at all. The market interest rate is the ‘price’ for a given form of debt, government bills for example, that balances supply and demand for that particular form. Government bills are NOT money.

    Regards, Don

  2. Matt Nolan
    Matt Nolan says:


    If we wish to keep the “general price level” stable it is not nonsense – as an increase in activity with no increase in the supply of money (or the velocity) will lead to a straight reduction in the price level (and some other more important problems in the case of nominal rigidities).

    That is why the second part of Friedman’s famous “Inflation is always and everywhere a monetary phenomenon” quote is:

    “in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

    “The market interest rate is the ‘price’ for a given form of debt”

    This is completely consistent with it being a price for money, after all there is a price in the market for coffee downstairs, one which I pay and one which the cafe receives.

    The interest rate defines the opportunity cost of holding money, that is what a price does.

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