Page One Economics is a tremendous resource for IB Economics teachers and students. I’ve been using it for a number of years, and I always look forward to a new edition. The latest one Inflation Expectations, the Phillips Curve and Fed's Dual Mandate written by Jane Ihrig, Ekaterina Peneva, and Scott A. Wolla is a jewel for us.
It starts off by clearly explaining what is meant by price
stability. Price stability is one of the main goals of macroeconomic policy.
Interestingly, it does not mean zero inflation.
Instead, the Federal Reserve (the US central Bank), as well as all
central banks, considers that “a moderate, stable and positive rate of
inflation is most consistent with its price stability mandate.” Why not target
zero (0%) inflation? It is explained
beautifully in the article. To protect
the economy from deflation is one reason (deflation is when the average price
level is decreasing which induces households to postpone purchases and thus forces
firms to cut wages and/or jobs leading to a deflationary spiral). The rate of inflation cannot be pinned at any
level but tends to fluctuate, so entering negative territory is to be avoided. Also,
there is an upward bias in measuring inflation meaning that if measured
inflation is 0.5%, it could actually be minus 0.4% having entered deflation
territory (see the Ellie Tragakes IB Economics textbook on this overestimation bias or the Oxford Economics Study Guide). In addition, if inflation is extremely low for
a long period, typically interest rates are also close to zero leaving no room
for an interest rate cut if the economy faces the risk of recession. This is the ZLB ('zero lower bound' problem –
see the new Oxford IB Economics Study Guide for a brief explanation of this). So, what do central banks mean by ‘price
stability’? If 0% inflation was not
desirable as a target, what rate of inflation should central banks aim for? We
know that high inflation is costly for many reasons. Inflation decreases the purchasing power of
all households with fixed money incomes (like wage earners or pensioners); it
increases income inequality as low income individuals can only save any income
they do not spend in bank savings accounts where the real interest rate earned (their real return of return) may be negative (remember, the real interest rate is the nominal
interest rate minus (expected) inflation) and they cannot borrow to
purchase (invest in) assets whose market value is expected to rise faster than inflation
(while richer folk can invest in real estate, art, gold, etc.); it distorts the
signaling power of relative price changes leading to allocative inefficiency; it leads to increased uncertainty that stifles investment and it renders exports
less competitive in foreign markets, among other costs. Where does this leave us? Well, the Fed, as
most central banks did, gravitated to a 2 percent ‘healthy compromise’. So, for
most central banks their announced target has been to achieve and maintain inflation
“below, but close to 2 percent”. The 2%
target has become the orthodoxy despite being a rather arbitrary choice. The story behind the choice is actually pretty funny.
The St. Louis article, after explaining why now the US central Bank has chosen the Personal Consumption Expenditures Price Index (PCEPI) over the CPI (from my understanding the PCEPI also corrects for the substitution bias that plagues the CPI – note here that IB Economics students should stick with the CPI as it is the CPI that is in the new IB syllabus), continues with a short but beautiful exposition of the Phillips Curve which all IB Economics students should read. The Phillips Curve reflects that (at least in the short run) there is a trade off between inflation and unemployment
"which policymakers considered when setting monetary policy: They could pursue an economy with lower unemployment if they were willing to accept higher inflation. Conversely, if policymakers wanted to pursue lower inflation, they would have to accept higher unemployment and lower economic activity."
Interestingly enough this “tradeoff has
weakened”. There is evidence that the “Phillips
Curve has flattened” (see "Is the Phillips Curve alive?") which allows them
to pursue lower unemployment without having to accept higher inflation.” Now,
in the US, “…policymakers are willing to allow employment to expand as long as
inflation expectations are anchored around the 2 percent target.”
The important phrase to note from the last quote is the phrase ‘… inflation expectations are anchored’. Expectations about future inflation are perhaps the most important determinant of inflation. Why? Because “they influence peoples’ decisionmaking today, which then impacts future inflation.” Read the box on page 4 of the St. Louis article as this is explained in a way that all IB Economics students will understand. If a firm believes that inflation will be around 2% this year and next year and the year after, it will increase its prices and wages by 2%, and based on this expectation, plan its investments. Similarly with households. It follows that if expectations are anchored at 2% then inflation will indeed prove to be 2%.
This brings us to my earlier July 2 post on the
Summers-Krugman inflation debate where Krugman distinguishes between 'transitory' inflation and ‘hard core’
inflation. I mentioned in the earlier
post Krugman’s definition of transitory inflation as “easy come, easy go” but you
will find a fuller explanation in the box titled “What is transitory inflation”
on page 5. You will then understand why
the Fed has recently slightly changed its target to what is referred to as “flexible
average inflation target” (FAIT). Inflation can now exceed 2%, as long as, on the
average, it remains at 2%. This really boils down to as long as peoples’ expectations
about future inflation remain anchored at 2% and a higher rate of inflation
does not become ‘embedded’ in their expectations.
This St. Louis article is a great resource for not just my but for all IB
Economics students. Not only will it
help them better understand inflation and policymaking (remember the Paper 3 new ‘recommend a policy’
part) but also provide them with plenty of real world information to satisfy a
number of possible Paper 1 macroeconomics questions.
Please read the St. Louis Page One Economics article!