Inflation

INFLATION

By the beginning of the 1980s, double-digit rates of inflation had become so pervasive among industrialized economies that they were viewed as a major deterrent to global economic growth. Since then, an explicit policy goal of low inflation has become a mantra for policymakers, and many countries, such as the U.K., New Zealand, Australia, Japan, Sweden, and the eleven countries under the European Central Bank (ECB), have enacted fundamental reforms to achieve that goal. Specifically, they have made their central banks more independent and thus insulated them from the temptations of inflationary finance; furthermore, in most of these cases, as well as in the U.S., central banks have practiced a greater degree of openness or transparency about monetary policy decision making to give the private sector a better opportunity to monitor their activities.

Today, these countries can claim considerable success in reducing both inflation and inflationary expectations. For example, despite the run-up in energy prices in 2000, consumer price inflation rates from 1999.Q3 through 2000.Q3 fell to 3.5% in the U.S., to 3.2% in the U.K., to 1.6% in the EMU countries, to 2.7% in Canada, to 0.9% in Sweden, and to 3.0% in New Zealand. Japan, with an inflation rate of -1.2%, is something of a special case, as it is just beginning to emerge from a prolonged recession.

With inflation rates now in the low single digits, attention has become more narrowly focused on the problem of determining quantitatively what the "optimal" inflation rate should be. Evidence to date suggests that policymakers’ views have coalesced, however tentatively, around a "2% solution" to this question. For example, consider these explicit inflation targets: 2.5% for the Bank of England, less than 2% for the ECB, 1-3% for the Riksbank in Sweden, 1-3% for the Bank of Canada, 0-3% for the Reserve Bank of New Zealand, and 2-3% for the Reserve Bank of Australia. While the Federal Reserve has no explicit inflation target, the U.S. inflation rate has averaged 3.0% since the end of the last recession in 1991.Q2. This Economic Letter addresses the question: How well is a "2% solution" to the inflation problem supported by the voluminous academic studies that have been conducted recently on the optimal rate of inflation?

The Friedman Rule and the benefits of 0% inflation

Milton Friedman (1969) described the optimal inflation rate as one that would not penalize households for holding monetary assets that bear no interest. This would require a zero nominal interest rate, such that the real return on money, which is the negative of the inflation rate, would exactly equal the real return on real assets. This so-called Friedman Rule has resurfaced in recent theoretical models. These models examine in an internally consistent manner how inflation leads to the inefficient use of the economy resources, and they quantify the significance of these inefficiencies by taking the models to the data.

Using the Friedman Rule as a benchmark, the standard measure of welfare losses associated with inflation is computed to be the percent change in the household consumption (or income) flow that the household would require to be indifferent between two inflation rates. The majority of the large number of theoretical studies devoted to this issue have produced estimates of the welfare costs of moderate inflation, say, of increasing the inflation rate from 0% to 10% that fall in the range of approximately 1/3% to 1-1/2% reduction in the household consumption (or income) flow.

Economists have estimated the magnitude of these welfare costs in several ways. Early studies (for example, Cooley and Hansen 1989) focused on inflation as a tax on consumption expenditures associated with monetary transactions; they found these costs to be toward the lower end of the range reported above. However, inflation induces additional distortions that raise the welfare costs. For example, the avoidance of inflation taxes also can divert resources away from production and into the payment system in order to increase the velocity of money. This response to higher inflation can take many forms, from households making more frequent trips to the bank or ATM machine, to firms devoting greater quantities of capital and labor toward enhancement of the efficiency of their cash management practices, to the emergence of non-monetary systems (often relying on electronic funds transfers) as a means of effecting final settlement of transactions. As inflation rises, more of the economy resources flow into transacting via these channels and less is available for production, thus reducing output and consumption and lowering welfare. In addition, higher expected inflation induces higher nominal interest