MABE 2009: Revision Questions

In this post, I will answer questions that some of you sent me while revising for exams.

1. As, Price stability suggests that inflation should be "low and stable", should we set inflation close to zero as possible? Is the result of setting inflation close zero mean that we will be at risk of deflation? And what is the appropriate rate of inflation (inflation Targeting) or it depend on each in country forecast as New Keynesian suggested?

This is a good question, and one that I didn't get to address properly in lectures. If price stability is so important, why don't we aim for zero inflation? After all, our ultimate aim is price stability rather than inflation stability. There are at least 2 reasons why, in practice, targeting a low but positive inflation may be a good idea.

First, as you stated, there is a danger of deflation, which can make monetary policy ineffective and thus can be very costly (Japan's lost decade is the prime example here). So, even if zero inflation may be desirable in principles, the upside and downside costs of missing your target is highly asymmetric: you are much happier to end up with 1% inflation, rather than -1%. Just to be on the safe side, targeting a small but positive inflation reduces the deflation risk.

Secondly, it is well-known that our measurement of inflation is imperfect, especially because we cannot account for the quality improvement of goods. For example, the cars' prices may rise every year, but does that mean we have a higher inflation, or simply that cars this year are better than last year model? Due to this unseen quality adjustment, economists are aware that our measured inflation is probably subject to upward bias: it tends to overstates the true inflation. Hence, while we may aim for close to zero inflation, in practice we target a slightly positive number.

What inflation number precisely? I think most central banks would agree that somewhere around 1-2% represents price stability. Countries with higher targets may be those whose inflation targets are still 'converging' towards their long-run ultimate objective.