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First of all, this report discusses the reasons why is it so important to reduce inflation, those different strategies used to control inflation and the benefits and limitations of using those strategies. Besides, this report also discusses about ways to achieve disinflation.
II.The Growing Consensus for Inflation Reduction
Inflation reduction and price stability should be set as the primary long term goal of monetary policy and this explains why so many countries have reduced their inflation rate in recent years, especially among the central banks and the public.
There was a so-called activist monetary policy supported by majority of the economics experts and public. For example, central bank tried to reduce unemployment rate by using expansionary monetary policy.
The activism was supported by 2 principles: First, the implementation of macroeconometric models has accurately predicted the implication of monetary and fiscal policy in the economy. Second, with the assumption made by Paul Samuelson and Robert Solow, they stated that there was a long-run Philips curve tradeoff that could be exploited.
Nevertheless, the author did not support monetary activism based on three arguments:
First argument, the monetarists led by Milton Friedman argued that there are drawbacks in Keynesian macroeconometric models which lead to long and variable lags in the effects of macro policy. There are 2 reasons why macroeconometric models are not useful in evaluating the impact of policy. First, the macroeconometric models cannot accurately forecast and predict the effect of policy. Last but not least, the "Lucas critique" presented by Lucas stated that the relationship between expectations and past information will vary, in which the past information will no longer be the correct model for evaluation.
Second argument, Milton Friedman argued that the Phillips curve trade-off is incorrect because its analysis has ignored the expectations of inflation. In fact, they should focus on real wages that are adjusted for any expected inflation. Friedman has modified the Phillips curve analysis into expectations-augmented Phillips curve that predicts a high rate of inflation is no longer associated with low rate of unemployment, vice versa, because for any level of inflation, the unemployment rate will adjust to its normal rate level. Therefore, there is no long-run trade-off unemployment and inflation.
Third argument, Kydland and Prescott, Calvo, and Barro and Gordon reviewed that there is a time-inconsistency problem faced by the monetary policymakers. They are always tempted to pursue a discretionary monetary policy that is more expansionary than firms expect because such a policy would boost economic output (or lower unemployment) in a short run. The best policy is not to pursue expansionary policy because decisions about wages and prices reflect workers' and firms' expectations about policy; when they see a central bank pursuing expansionary policy, workers and firms will raise their expectations about inflation, driving wages and prices up. The rise in wages and prices will lead to high inflation, but will not result in higher output on average.
Afterall, the long-term goal for monetary policy is price stability. In the long run, price stability promotes economic growth as well as financial and interest-rate stability. Price stability is desirable because a rising price level (inflation) creates economic costs to the society.
III.Strategies for Controlling Inflation
In order to control inflation, central banks have implemented four types of strategies, which includes :
1)Exchange Rate Pegging
This is a way for the country to keep inflation low by pegging its exchange rate at its fixed value to a large and low-inflation country. In other way, crawling peg or target also used by some country to reduce its currency value at a stable rate in order to raise its price level compared to that particular country.
Advantages: The first and main advantage of this type of strategy is that, it provides a nominal anchor which can limit the time-inconsistency problem. Exchange rate peg indicates an automatic monetary policy rule which ties down the domestic price level to achieve price stability, vice versa.
Second advantage is that, exchange rate peg is considered simple and clear, and therefore the public is easy to understand it. An exchange rate peg has been used successfully in some industrialized countries such as France and United Kingdom, which peg their value to the German mark. This results in the reduction of inflation rate in both countries.
In order to effectively reduce inflation, there must be a strong commitment mechanism to peg the exchange rate. This refers to currency board, in which an announcement made by the central bank or the government regarding to the fixed exchange rate against a particular foreign currency. Therefore, domestic currency will be exchanged for foreign currency based on that fixed rate. Argentina is one of the countries that used the currency board to bring down its inflation rate by exchanging U.S dollars for new pesos.
Despite that the currency board system restricted the central bank to act as a lender of last resort, it is somehow known as the best way to solve the country's inflationary problem.
Disadvantages: When the pegged country fixed its currency with that anchor country, it is constrained in using monetary policy to adjust its interest rate if there are any changes in the pegged country's economy.
Next, Obstfeld and Rogoff(1995) stressed on their point of view that there will be a speculative attacks on the pegged country's currencies. The aftermath of German reunification caused a European exchange rate crisis in 1992 which generally affected the French franc, the Spanish peseta, the Swedish krona, the Italian lira and the British pound.
A successful speculative attack on the country's currencies will eventually increase the rate of inflation especially when there is a depreciation of the currency. Most of the emerging market countries especially Mexico, would be the example in this case. It will also lead to a fluctuation in financial crisis.
The responsibility of the policymakers may be lessen in practicing an-inflationary policies because a pegged exchange rate cannot provide early signal to the public and policymakers. So, they cannot forecast on the stance of monetary policy and cannot take immediate action to adjust the policy.
Hence, it is said to be dangerous to peg the exchange rate in emerging market countries compared to industrialized countries as they are more vulnerable in certain disastrous consequences. But, not all emerging market countries face such problem, like United Kingdom.
Another strategy for controlling the inflation is monetary targeting. According to the suggestion of Milton Friedman, the constant-money-growth-rate rule has been used in monetary targeting. Monetary targeting is flexible because the monetary-targeting central bank does not necessary follow the rules for monetary growth.
Advantages: Compared with exchange rate pegging, monetary targeting allows the central bank to modify its monetary policy to deal with domestic changes. Besides, central bank can select own inflation goals and response to the output fluctuations.
Somehow, monetary targeting also has two similar advantages with exchange rate pegging. First, a nominal anchor is provided to reduce the inflation rate. It is able to send immediate signals to the public and markets which provide the information about the stance of monetary policy in order to reduce inflation. Second, it can help to solve the time-inconsistency problem by allowing immediate accountability for monetary policy. Germany would be the best example in engaging monetary targeting and it is considered successful.
Disadvantages: The achievement of the monetary targeting depends on 2 big ifs. First, a strong and reliable relationship must exist between the goal variable and targeted aggregate. If the relationship is weak, the monetary targeting will not perform well, and this happened in United States.
Last but not least, to ensure that the monetary aggregate will provide clear signals to the public and markets, the central bank is responsible in controlling the targeted monetary aggregate.
Inflation targeting is one of the strategies of monetary policy. It involves several elements such as the public announcement of medium-term numerical objectives (targets) for inflation, an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal. It also increased transparency of the monetary policy through communication with the public and increased accountability of central bank.
Advantages: Inflation targeting has the key advantage that it is readily understood by the public as it is highly transparent. Because an explicit numerical inflation target increases the accountability of the central bank, inflation targeting has the potential to reduce the likelihood that the central bank will fall into the time-inconsistency trap of trying to expand output and employment in the short run by pursuing overly expansionary monetary policy.
With inflation targeting, stability in the relationship between money and inflation is not critical to its success because it does not rely on this relationship. On the other hand, monetary authorities are required to use all available information to conduct the most appropriate monetary policy.
Besides, inflation targeting also focuses on the political debate in controlling the inflation to permanently increase economic growth by pursuing expansionary policy. Canada would be the example in this case.
It was shown that there was a success in New Zealand, Canada and United Kingdom which conducted inflation targeting.
Disadvantages: Monetary authorities feel that it is difficult to control inflation and they are unable to immediately respond to the inflation due to long lags in the effect of monetary policy. That is why immediate signals could not be sent to the public and markets regarding the stance of monetary policy. Nevertheless, these signals provided by monetary aggregate are weak, hence, it is not at all clear that monetary targeting is superior to inflation targeting on these grounds.
There was a critics regarding to inflation targeting stated by Friedman and Kuttner(1996). They strongly believe that there was too much rigidity on the rule towards those monetary policymakers. Thus, it limits their ability to respond to unforeseen circumstances. According to Mishkin, he disagreed with the critics because successful policy strategies include forward-looking behavior that will prevent policymakers from conducting the unprofitable policies.
We can describe inflation targeting in two ways. First, according to Bernanke and Mishkin(1997) and Mishkin and Posen(1997), inflation targeting is not considered as the rigid rule. Second, there was a potential degree of policy discretion in the conduct of inflation targeting which is based on economic circumstances.
An important criticism of inflation targeting is that a sole focus on inflation may lead to monetary policy that is too tight when inflation is above target and thus may lead to larger output fluctuations. Inflation targeting required inflation targeters to display substantial concern about output fluctuations. All the inflation targeters have set their inflation targets above zero.
However, evidence shown that even though inflation targeting helps to reduce inflation but it will also slow down the growth and increase unemployment rate.
Due to the undesirable outcome from the inflation targeting, some economists suggested that central banks should focus on the nominal gross domestic product(GDP) growth rate which stressed on the importance of output and prices(Taylor,1985; Hall and Mankiw,1994). Cecchetti(1995) also suggested that nominal GDP targeting is more useful than inflation targeting to produce better outcome.
However, there are two reasons why inflation targets are more desirable than nominal GDP targets. First, a nominal GDP requires the central bank to declare the potential GDP growth but this cause a lot of problem because it is hard to forecast the future GDP growth as it changes over time. Second, public might misunderstand the concept of nominal GDP with real GDP and this might confuse the public. Therefore, inflation targeting is considered more useful than nominal GDP targeting.
4)Just Do It : Preemptive Monetary Policy without an Explicit Nominal Anchor
This strategy involves forward-looking behavior in which there is careful monitoring for signs of future inflation using a wide range of information, coupled with periodic "preemptive strikes" by monetary policy against the threat of inflation. In this case, United States has successfully control its inflation rate by conducting a monetary policy with an implicit nominal anchor.
As we mentioned before, there is a long lags effect on monetary policy. Therefore, policymakers must look forward and act preemptively before inflationary surge. The difference between "just do it" strategy and inflation targeting is that it does not have nominal anchor and is less transparent.
Advantages: The main advantage of the "just do it" strategy is its demonstrated success. The Federal Reserve reduced inflation in the United States over the last fifteen years, which is arguably consistent with the price stability goal. The second advantage is that the central bank's forward-looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby ameliorating the time-inconsistency problem.
Disadvantages: One disadvantage of the strategy is its lack of transparency. This creates economic uncertainty and leads to unnecessary volatility in financial markets. Low accountability may make the central bank more susceptible to the time-inconsistency problem. The absence of nominal anchor may lead to high inflation when there is an economic downturn.
The most serious problem with the "just do it" strategy is its strong dependence on the preferences, skills and trustworthiness of the individuals in charge of the central bank, such as the chairman of the central bank. For example, if the chairman of a particular central bank does not emphasize the goal of price stability, the possibility of high inflation will occur.
Therefore, it is important for the central bank to have some degree of independence, and the evidence does generally support central bank independence.
As we discussed above, there are four strategies used by the central banks to control inflation, which includes exchange rate pegging, monetary targeting, inflation targeting and "just do it" strategy. The usefulness of each strategy depends on the economy situation of that country. But, it is important for the policymakers to focus on price stability in the long run in order to maintain its economic stability.
From our point of view, "just do it" strategy is more preferable in reducing the inflation rate in the long run. Somehow, it is even better to formalize the strategy by making explicit a commitment to a nominal anchor as with inflation targeting. This is because we must behave in a forward-looking fashion and act well before a disaster strikes.