Discussion on how to screw up a terms of trade increase

According to Statistics New Zealand our terms of trade is now at its highest point in almost three and a half decades. To some degree this lift appears to be structural, with growing demand for protein goods from Asia and the increasing prevalence of biofuels two of the main factors driving up prices permanently.

However, Berl and the Hive have identified what they believe to be the main policy factors that could mess up our chance to take advantage of this national increase in income (h.t. the Hive). These factors were Inflation targeting (Berl) and the Emissions trading scheme (the Hive).

Here I aim to discuss the Berl argument – the warning is that it might sound a bit technical (more down to my inability to explain myself clearly than anything else 🙂 ). After that I will do another post on the argument that the Hive raised, and maybe even state what I think is a major policy risk 🙂

The Berl criticism: Inflation targeting

Fundamentally, the Berl criticism relies on the belief that there is a long-run trade-off between inflation targeting and output – as illustrated by this quote:

Are you happy to continue to `buy’ price stability at the cost of a perennially underperforming economy?

Now the only factor that could cause a long run trade-off between a real variable such as output and a nominal variable such as the price level is Hysterisis or path dependence. If inflation rates can give us a higher level of short-run growth, and short-run growth drives long-run growth then inflation can increase long-run growth.

However, I believe any such Hysterisis that exists is trumped by the fact that higher inflation rates increase price volatility and hurt the price signal. This reduces allocative efficiency and also increase uncertainty, reducing investment and causing direct welfare loss.

Now, another potential way to read their criticism is that inflation targeting is not the best way to limit welfare losses from price and output volatiltiy, given that we have price and output stickiness.

What I mean by all this jargon is that prices tell us how we should distribute resources based on peoples willingness to pay. If we suffer from a “shock” to economic activity some prices and some levels of output will not change initially to meet this, implying that the allocation of resources will become inefficient. The real interest rate is a tool that can be used to change output and price levels in other sectors of the economy in order to try and move us back to the most efficient allocation of resources.

However, take for example the case where we have a negative supply shock, such as higher oil prices. If we assume no change in the optimal set of relative prices, then the optimal output should decline relatively evenly. As this is an increase in costs firms that can’t change output will lift their prices and increase stocks (although the magnitude is uncertain). Meanwhile the firms that can’t change prices will reduce output. If the Bank reacts to the higher prices by lifting interest rates (reducing demand) they will likely reduce the price setting firms increase in prices – however, they will increase the accumulation of stocks.

In an aggregate sense this implies that dealing with price pressures will lead us to move further away from our “natural rate of output”, so in the case of supply shocks we suffer a trade-off between inflation volatility and output volatility.

As the economy is just a continuing set of these short run games, the focus on inflation stability could well lead to greater volatility in output – which will reduce welfare (given that individuals are risk averse) and with the existence of factors such as “learning by doing” in the industries, may lead to a reduction in efficiency.

But …

The games discussed about did not take into account the difference between a discretionary central bank and a central bank that can commit to inflation levels – thereby influencing the way contracts are structured.

The beauty of inflation targeting is that it provides a pre-commitment mechanism that tears us out of this world of trade-offs between inflation and output. As long as price-setters believe that the Central Bank will deal with inflationary pressures over the medium term, the Bank is allowed to deviate from its target to reduce output volatility in the face of a shock (*) – however the Bank only has this credibility if it settles down and sticks to its target during periods of time that are not subject to large external shocks, hopefully Bernanke is about to show us how this works (*).

As a result, I do not believe that inflation targeting is putting this terms of trade boost at risk – as long as the Reserve Bank keeps credibility they are providing us with an environment where we can fully take advantage of the greater claim on resources that comes with a positive terms of trade shock (higher world food prices for a net food exporter).

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  2. […] on how to screw up a terms of trade increase II 20 06 2008 As promised, I will now discuss Queen Bee’s fear that the Emissions trading scheme will limit our ability […]

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