Revisit Zero Inflation Policy: Feasible or Mirage? Ruilin Tian* April 4, 2013
*
Department of Accounting, Finance, & Information System, College of Business, North Dakota State University, P.O. Box 6050, Fargo, ND 58108-6050. Email:
[email protected].
Revisit Zero Inflation Policy: Feasible or Mirage? Abstract This paper revisits the zero inflation policy in the post Great Recession period to bring the most updated facts about the effectiveness of the policy in the United States. We analyze the major benefits and costs of zero inflation. We point out that the benefits of the policy are not as significant as people thought, while the costs can easily exceed the benefits. In addition, we discuss the feasibility of the policy. The money wage rigidity, people’s suspicious attitude toward the disinflation policy, and the presence of zero lower bounds (ZLB) of interest rates place dramatic barriers to the implementation of the zero inflation policy, making it almost infeasible. Therefore, the Federal Reserve should achieve a balance between the costs and benefits of preventing inflation rather than target at zero inflation.
Keywords: Zero Inflation, Unemployment Rate, Sacrifice Ratio, Monetary Policy. JEL Classification: E24, E5
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Revisit Zero Inflation Policy: Feasible or Mirage? 1. Introduction Effectively maintaining stable prices is one of the main mandates of the Federal Reserve. It is critical to determine a proper “target” inflation rate and attempt to steer actual inflation towards the target. Inflation targeting was initially proposed by Bernanke & Mishkin (1997) and required a decision made on what price stability means in practice. Alan Greenspan has provided a widely-cited definition of price stability as a rate of inflation that is sufficiently low that households and businesses do not have to take it into account in making everyday decisions. Now the question is: What objective should we seek for the rate of increase of average prices? Should we strive for no change at all, that is, zero inflation, or should we target an inflation rate higher than zero? On January 25, 2012, Chairman Ben Bernanke set a 2% target inflation. Is it the best choice for the current US economy? Williams (2006) proves that with effective communication between the policy holders and the public, zero inflation policy could be a good choice when the public forms expectations using the true monetary policy rule. This is quite feasible considering that the Federal Reserve policymakers started to release their projections for output growth, unemployment, and inflation to the public more frequently and with greater detail since November 2007 (“Publishing Rate Forecasts”, 2008). Therefore, it is worth revisiting the zero inflation policy and investigating its positive and negative effects on the economy. Zero inflation is a state in which there is no inflation. Woodford (2000) defines the Wicksellian natural rate of interest to be the real rate that yields period-by-period price stability. Therefore, the natural rate of interest is the real interest rate when the actual output equals the potential output. Since complete price stability has attractive features, many economists and policymakers advocated zero inflation as an appropriate target for economy stabilization 15–20 years ago, especially after inflation surged to double-digit levels in the early 1980s. After the US economy went through the Great Recession in the late 2000s, concerns about high inflation and advocacy for zero inflation have diminished. We observed the third attempt of Federal Reserve to stimulate the economy, known as quantitative easing and often abbreviated as QE3, launched on September 13, 2012. The policy deals with buying long-term bonds such as mortgage-backed securities. This policy will put downward pressure on longer-term interest rates. The Federal Reserve indicated that it plans to keep short-term interest rates at "exceptionally low levels" until 2
mid-2015. It seems that the Federal Reserve is more worried about the high unemployment than possible inflation. However, one should be aware that only an unanticipated change in money supply (usually in the short run) can increase output and reduce unemployment. In the long run, only the price level will rise but the output will remain unchanged. Leduc et al. (2009) find that since the start of the recession the level of disagreement about the inflation forecast has risen due to the fears that inflation will take off. The continuous quantitative easing could put pressure on inflation in the future when the economy walks out of the recession and triggers another boom. During the last four years, the Federal Reserve has tripled the monetary base without inflation surging partially because the money multiplier process has broken down (Williams, 2012b). But once the economy improves sufficiently, the money multiplier could reassert itself and lead to a huge increase in the money supply and high inflation. Therefore, zero inflation policy is accumulating its potential possibility and will draw more attention in the next decade even if the policy does not show its immediate attractiveness currently. The idea of zero inflation goes back to classical economics and has inspired countless monetary-reform proposals during the last 100 years. The double-digit inflation in the late 1970s triggered serious discussion about achieving price stability in the 1990s. Participants included policymakers from the U.S., Britain, Germany, and Japan. For example, former Federal Reserve Chairman Alan Greenspan once expressed sympathy for zero inflation, claiming that achieving price stability “is a testament to the effectiveness of the conduct of monetary policy around the world in bringing inflation to heel” (Selgin, 1995). On the other hand, there were many debates about zero inflation in academia. Howitt (1990) makes a persuasive case that zero inflation is probably the best inflation rate to inherit, but his analysis of the transition costs leaves him uncertain whether to recommend going all the way to zero. Aiyagari (1990) compares the costs of going to zero from a 5% inflation trend with the benefits of being at zero and concludes that the costs exceed the benefits. However, Carlstrom & Gavin (1991) point out that estimates of both the resource costs and benefits associated with disinflation can vary widely depending on the assumptions used in the analysis. For example, Gordon & Mankiw (1996) show that in the long run, a moderate steady rate of inflation permits maximum employment and output while maintenance of zero inflation measurably increases the sustainable unemployment rate and correspondingly reduces the level of output. But Neal (1992) believes that Congress should pass legislation to establish zero inflation in order to achieve the highest sustainable levels of 3
economic growth, employment, savings, capital formation, investment, productivity, competitiveness and efficiency. Wolman (1997) claims that optimal rate of inflation should be negative. He argues that rather than push inflation to zero, one should make the nominal interest rate zero in order to maximize the social welfare, the so-called Friedman rule (Friedman & Schwartz, 1963; Friedman, 1969). Feldstein (1997) argues that going from low inflation to price stability involves a short-term loss and results in a series of welfare gains in the long-term. However, Akerlof et al. (1996) think that setting inflation at too low a level produces inefficiency and will increase the natural rate of unemployment. More recent studies such as Hamilton & Wu (2012) turn their attention to the effects of the maturity structure of publicly held debt on the term structure of interest rates when the shortterm interest rate is at the zero lower bound (ZLB). The ZLB refers to a state in which nominal interest rates are near zero and could not be lowered further for the Federal Reserve to implement expansionary monetary policies. Feldstein (2010) notes that those who emphasize the risk of inflation often point to America’s enormous budget deficit because they worry that the government will actually choose a policy of faster price growth to reduce the real value of the government debt. Wolman (2011) computes the optimal inflation rate using personal consumption price and quantity data for the United States. He comes up with an optimal inflation rate of -0.4%, but the estimation is sensitive to the relative degrees of price stickiness. Wolman’s (2011) results provide model supports to the zero inflation policy. This paper revisits the zero inflation policy using data covering the first decade of the 2000s. We analyze the positive and negative aspects of zero inflation in term of its benefits, costs, and feasibility, proving that in the real world, the costs of zero inflation can easily outstrip its benefits. The price inelasticity of money contracts brings about short-run costs of disinflation. The public’s low confidence in the zero inflation policy enlarges the costs of implementing it. Actually, even if the benefits of zero inflation compensated for its costs, which would make zero inflation a worthwhile policy, the policy is still not feasible. The biggest obstacle comes from the money wage rigidity that makes the unemployment costs of zero inflation extremely high. This downward rigidity not only increases the costs of zero inflation policy, but also makes it almost infeasible. People’s suspicious attitude to the disinflation action of their countries’ central banks places another barrier to the policy implementation. In addition, the presence of zero lower bounds (ZLB) of interest rates makes the zero inflation policy even less attractive. Therefore, an 4
advisable choice for the Federal Reserve is to abandon the zero inflation goal and instead to maintain a relatively low and stable inflation, the so-called “inflation targeting” (Bernanke & Mishkin, 1997; Svensson, 1997). This strategy would allow the Federal Reserve to take advantage of the “inflation grease” while avoiding side effects from high inflation. The paper is organized as follows. In Section 2, we discuss the possible methods central banks may use to decrease inflation. We then analyze the major benefits and costs of zero inflation. We point out that the benefits are not as large as people assumed, while the costs expressed with the sacrifice ratio cannot be compensated by the benefits of price stability. Section 3 talks about the feasibility of zero inflation policy. We show that due to the money wage rigidity, the public’s suspicious attitude toward the disinflation policy, and the existence of ZLB of nominal interest rates, stabilizing price level is not feasible. In section 4, we provide an overview of the current US economy in terms of GDP growth, inflation, and unemployment rate. We conclude that the Federal Reserve should abandon the so-called zero inflation policy and instead pursue a low and stable inflation to achieve an optimal tradeoff between the benefits and costs of inflation manipulation. Section 5 concludes the paper.
2. Benefits and Costs of Zero Inflation 2.1. Methods of disinflation In both academia and policymaking, analysis of inflation and economy stabilization typically rests on a natural unemployment rate model. The model holds that inflation will accelerate or decelerate depending on whether unemployment is below or above the natural rate. Only when the unemployment rate is at its natural level does the rate of inflation remain unchanged. For example, Liu & Rudebusch (2010) point out that the Phillips curve relationship between unemployment and inflation has been held since the recession started in late 2007—a high level of unemployment has contributed to a decline in inflation. However, this inverse relationship breaks down in the long run. The long-run Phillips Curve is vertical, which indicates there is no trade-off between inflation and unemployment in the long run. This suggests that it would be possible to achieve zero inflation at a fixed long-term unemployment rate. In general, there are two types of inflation: demand inflation and supply inflation. Demand inflation is caused by an acceleration of the growth rate of nominal aggregate demand due to changes in consumption, money supply, government spending, tax rates, transfers and net
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exports. Supply inflation, on the other hand, results from a supply shock that suddenly changes the price of a commodity or service. The available policy strategies to reduce inflation are very limited. In most cases, policymakers choose a contractive monetary policy to achieve a lower inflation target. Monetary policy is preferred here because the fiscal policy is more difficult to carry out and some contractive effects of fiscal policy can be offset by the policy feedback. When contractive monetary policy is implemented, as the money supply decreases, employment and output are negatively affected. The decrease of income will shrink tax revenue and lead to government budget deficits, the so-called cyclical budgets. Furthermore, if the government expends expenditure to encourage spending and reduce unemployment, its monetization incentive will rise since budget deficit cannot be easily avoided. Cutting budget deficit will hurt our initial target of disinflation, more or less. An alternative remedy is to advocate technology development. Increasing the level of technology shifts the aggregate supply curve to the right, reducing inflation and increasing real GDP at the same time. But this is a long-run policy. It takes years to observe effects. On the other hand, people need to sacrifice short-run production and transfer some resources that could otherwise be used to develop technology. In addition, since technology development is confined by many complicated factors, it cannot be determined simply by inputs of resources.
2.2. How to evaluate benefits & costs A reasonable economic measure of benefits/costs of government policies is to calculate the aggregate satisfaction/dissatisfaction of an individual. Generally economists define the satisfaction of an individual as the gratification of consuming goods and services and the pleasure of enjoying leisure time. In order to easily compare the costs with benefits, Aiyagari (1990) translates the value of satisfaction into percentage of GDP. Following his method, in Section 2.3, we will discuss the benefits in terms of GDP when zero inflation policy is implemented. However, policies that tend to change inflation are rather difficult to analyze. Since inflation’s effects on the economy are so complex, we will discuss only a few essential features here.
2.3 The benefits of zero inflation It is widely believed that there are three major benefits of zero inflation: reduction in the costs of transactions, reduction of capital income tax, and reduction in uncertainty. These 6
benefits are addressed by studies such as Aiyagari (1990), Aiyagari (1991), Hoskins (1991), Akerlof et al. (1996), and Durham (2001). 2.3.1 Reducing Transaction Costs Eliminating inflation encourages people to hold more cash for spending. This is because inflation wastes resources every time people convert interest-earning assets into cash. The “cash” here carries a broader meaning that embraces all non-interest bearing assets, such as currency and currency equivalents that can be accessed immediately and demand deposits that can be accessed almost immediately. Eliminating inflation would save those resources for productive uses. Inflation increases nominal interest rates and the opportunity costs of holding money, so people tend to hold less cash and invest more in interest-earning assets. When people need to use cash, transaction costs occur. Fig. 1. Historical Inflation Rates in the United States 20.00%
15.00%
10.00%
5.00%
0.00%
1947-01-01
1960-09-09
1974-05-19
1988-01-26
2001-10-04
-5.00%
-10.00%
Fig. 1. Rates of inflation in the United States from 1947 to 2012. The inflation rates drawn in the solid blue line are calculated based on quarterly data of Consumer Price Index for All Urban Consumers: All Items (http://research.stlouisfed.org/fred2/categories/9). The dotted red line is the trend inflation calculated as a centered, nine-quarter moving average of actual inflation.
Fig. 1 reports the inflation rates of the United State from 1947 to 2012. The solid blue curve shows the annualized inflation calculated from quarterly data of Consumer Price Index for All Urban Consumers: All Items1. The dotted red line is the trend inflation calculated as a centered, nine-quarter moving average of actual inflation. If we follow Fisher (1981), Lucas (1981), Cooley & Hansen (1989), and Aiyagari (1990), we can figure out the benefit of 1
Source: http://research.stlouisfed.org/fred2/series/CPIAUCSL
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eliminating inflation in terms of GDP. Aiyagari (1990) thinks that a 10% reduction in inflation will produce a transaction cost benefit of 0.08% at the lowest and 0.45% at the highest of the total GDP. The annualized average inflation in the last five years (08/2007–07/2012) is 2.19%, so the benefit of zero inflation ranges from 0.018% to 0.098% of GDP. Although the derivation seems a little arbitrary, we can use it to roughly gauge the transaction costs of inflation. Taking into consideration the proportion of currency held by law-abiding U.S. residents, the benefits of transaction cost saving will reduce significantly. The “currency” here has a similar meaning as the “cash” we defined before. Over 80% of U.S. currency is held abroad or by those who are engaged in illegal activities related to the underground economy. As a world currency, the U.S. dollar is generally accepted by most countries. National banks in other countries reserve the U.S. dollar to stabilize their exchange rate and import products and technologies. If the inflation were eliminated, resources would be transferred from U.S. citizens, who don’t use U.S. currency a lot, to citizens of other countries, who do. So eliminating inflation with some costs implies some loss of U.S. welfare. Inflation itself is a type of tax. In most cases, inflation occurs when government increases its spending. Government reduces its deficit caused by extra spending by printing money or issuing bonds that are eventually repaid by printing money. This will transfer resources from the public to the government. If inflation were eliminated, the government would likely replace the “inflation tax” with another revenue-raising tax. Therefore, eliminating inflation cannot reduce tax. Tax would still exist, very likely kept at its previous level but collected in different forms. If we take into account the effect of inflation on miscreant trades, price stabilization policy may even produce side effects! For those who take on underground economy activities and use currency extensively, removing inflation would eliminate a beneficial tax. Miscreant activities such as prostitution and the illegal drug trade are detrimental to the welfare of law-abiding people. Most of these illegal activities are done under tax evasion. Eliminating inflation may even encourage their cash transactions. Policymakers cannot find a better way to “tax” these illegal activities other than “charge” them via inflation. Therefore, the benefits of reducing transaction cost through zero inflation are not as high as many people thought. It should be far below 0.018%–0.098% of total GDP as calculated following Aiyagari (1990).
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2.3.2 Reducing Capital Income Tax Reducing capital income tax is considered as another benefit of zero inflation. Eliminating inflation rate can reduce firms’ capital income tax through tax shields of capital depreciations. Price stability would raise the real value of the depreciation deducted by businesses. Shifting the tax burdens away from corporations improves welfare. Since depreciation will be subtracted from a company’s before-tax revenue, it reduces the capital income tax and is considered as a kind of benefit to the company called tax shield. In general, when calculating the tax shield, businesses refer to the historical value (book value) instead of the market value of the original investment. With non-zero inflation, the company will lose some benefits from tax shield because tax rates are not inflation-indexed. In other words, inflation increases the effective tax rate borne by the company. Without inflation, there is no difference between historical and market values, so the effective tax rate on capital income is lower. Table 1. – Loss of Tax Shield under Rate of Inflation 2.5% Year1
Year2
Year3
Book value
$12,000
$12,000
$12,000
Market value
$12,300.00
$12,607.50
$12,922.69
Loss due to inflation
$300.00
$607.50
$922.69
Nominal rate
3.53%
NPV of Loss
$1,688.23
Table 2. – Loss of Tax Shield under Rate of Inflation 0% Year1
Year2
Year3
Book value
$12,000
$12,000
$12,000
Market value
$12,000
$12,000
$12,000
Loss due to inflation
$0
$0
$0
Normal rate
1%
NPV of Loss
$0
Here is a small example. Suppose a company purchases a machine at market value $120,000 at year 0. This expenditure will be written off as depreciation in the next 3 years, obeying the rule of straight-line depreciation. If the salvage value is zero, the book value of annual depreciation is $120,000/4 = $30,000. If the marginal tax rate is 40%, the tax shield obtained by the company per year from annual depreciation of $30,000 is $30,000*40% = $12,000. Since all accounting entries are recorded based on book values, the deduction of taxable 9
income is reduced due to the presence of non-zero inflation. If the property is appreciated at the inflation rate, the market values of annual depreciation shown in the third rows of Table 1 and Table 2 are calculated as:
MVt = D × (1 + π )t ,
t = 1, 2,3,
(1)
where D is the book value annual depreciation and π is the average rate of inflation. Table 1 and Table 2 assume the average expected inflation rate in the subsequent three years is 2.5% and zero, respectively. The dollar losses of tax shield per year are the difference between the market value and book value of annual depreciation, which are reported in the fourth rows of the tables. Suppose the real interest rate is 1%. Based on Fisher’s Law, the nominal interest rate for Table 1 equals 1%+2.5%+1%*2.5% = 3.53%. If instead a zero inflation policy is implemented (Table 2), the nominal interest rate would be equal to the real interest rate, which in our example is 1%. Using the nominal cost of capital, one can calculate the net present value (NPV) of losses of tax shield as:
NPV =
Loss3 Loss1 Loss2 + + , 1 2 (1 + r ) (1 + r ) (1 + r )3
(2)
where Lossi is the loss of tax shield in year i and r is the nominal cost of capital. The last row of Table 1 and Table 2 report the losses of tax credit in terms of net present value (NPV). The results show that the loss of tax benefits at 2.5% inflation is about $2,131.20/$120,000 = 1.41% of the initial investment. Reducing capital income tax will increase capital stock in the long run. However, to increase the long-run capital investment, one has to save more and sacrifice some current consumption, which slows down the short-run GDP growth. Therefore, the net benefit of reducing capital income tax is not as high as we expect. According to Aiyagari (1990), 5% decrease in inflation in the long run can only bring 0.10% –0.20% welfare benefit of consumption. So under 2.19% inflation rate (average of the last five years), the welfare benefit will shrink to 0.044%–0.088% of GDP. Furthermore, these benefits cannot be directly counted towards the zero inflation policy, since it is impossible to achieve the benefits without the involvement of some other economic variables such as inventory, investment, consumption, expenditure, etc. An alternative way to replace the zero inflation policy while remaining at least the same tax benefits is to reduce taxes. Aiyagari (1990) thinks that “indexing depreciation allowances to 10
inflation would lower the tax rate and produce the same welfare benefit without any costs that might come from reducing inflation”. 2.3.3 Reducing Uncertainty Lucas (1972), Vining & Elwertowski (1976), and Parks (1978) believe there is a positive correlation between inflation and output. This positive correlation suggests that a change in output might be related to an unexpected expansion of money supply instead of a real change in the supply/demand of goods and services. In a market economy, price is determined by the equilibrium of supply and demand. Change in price of a commodity or service is considered as a sign of change in the supply of or demand for that commodity or service. This signal will lead to a flow of resources to build a new equilibrium between supply and demand. So the accuracy of price signals warrants the efficiency of resource allocation. However, inflation disrupts the system, making the price signals distorted. With inflation uncertainty (perhaps caused by, for example, unexpected inflation or high volatility of inflation), it is very hard to probe the reason for a price change—whether it is caused by inflation or a real change in supply and demand. Decision-making becomes difficult and sometimes misleading. Output may be adjusted in response to price changes due to inflation instead of the real shifts of supply and demand. Under these circumstances, the inflation uncertainty will cause the resource misallocation, which in turn leads to the uncertainty of future prices and profits. However, it is inflation variation (usually measured by variance) that causes the inflation uncertainty. The cost of inflation uncertainty is incurred by the inflation volatility instead of the inflation itself. Any non-zero inflation, if it is expected, does not distort the important economic information delivered by prices. The level of inflation is affected by the interaction of real output growth and change in money supply/demand. Inflation volatility, on the other hand, is determined by the economic shocks and the ways by which monetary and fiscal policies respond to the shocks. Although in most cases low inflation tends to be more stable and high inflation tends to be more volatile, it is improper to consider inflation level and inflation volatility the same thing2. Since nobody can exactly predict all possible shocks, the only way to completely remove inflation uncertainty is to reduce the inflation variation to zero. The zero inflation policy 2
Statistically, the mean and variance of a random variable are different. Considering the inflation rate as a random variable, the level of inflation is the mean of the variable while the inflation uncertainty is measured by the variance of the variable.
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that reduces the level of inflation does not automatically reduce the inflation variation. This means that the benefits of reducing inflation uncertainty by lowering the level of inflation to zero cannot be obtained directly. If the correlation between the level of inflation and its volatility is not high enough, pursuing a zero inflation policy may not be worthwhile.
2.4 The Costs of Zero Inflation The discussion in Section 2.3 shows that the benefits of zero inflation are not as high as people thought. Let’s investigate the costs of zero inflation policy. 2.4.1 Sacrifice Ratio Sacrifice ratio is the loss of outputs when 1% inflation decrease is achieved. It measures the costs associated with slowing down economic output to change inflationary trends. It is one of the major costs that zero inflation policymakers have to bear if they use demand-side policy to achieve their inflation target. To calculate sacrifice ratio, following Ball (1994), the first step is to identify disinflations episodes in which the trend inflation falls substantially. The trend inflation is defined as a centered, nine-quarter moving average of the actual inflation. That is:
π t* =
π t − 4 + π t −3 + ... + π t +3 + π t + 4 9
,
(3)
where π t and π t* are the actual inflation and trend inflation at time t, respectively. So the trend inflation is a moving average of the actual inflation. In order to define disinflation episodes, we identify peaks and troughs based on the trend inflation. A peak is a quarter in which the trend inflation is higher than in the previous four quarters and the following four quarters, and a trough is defined similarly vis-à-vis four quarters on either side of the current time period. That is, pπ t* = {π t* | π t* > π s* for s = t ± 4, t ± 3, t ± 2, t ± 1} tπ = {π | π < π * t
* t
* t
* s
for s = t ± 4, t ± 3, t ± 2, t ± 1}
,
(4)
where pπ t* and tπ t* are a peak and a trough at time t, respectively. Therefore, a disinflation episode is the period that starts at an inflation peak and ends at a trough. We further require the annual inflation rate at a trough should be at least 1.5% lower than its paired peak in order to ensure it is a substantial disinflation rather than a random change. This also guarantees that an episode is not ended by a brief increase in inflation in the midst of a longer-term decrease. In addition, the inflation rate difference between a peak and its paired trough should be no higher 12
than 20% so that the period is not a recession, since sacrifice ratio makes no sense during recession. So for a disinflation episode that starts at a peak at time t and spans k periods, the sacrifice ratio SRt is calculated as:
yt +i * i =0 t +i , SRt = − pπ t* − tπ t*+ k −1 k −1
∑ log y
(5)
where yt and yt* are the real and tread outputs at time t, respectively. To calculate the trend output, we follow Ball (1994) to assume that (a) output is at its trend or natural level at the start of a disinflation episode, i.e., at the inflation peak; (b) output returns to its trend four quarters after an inflation trough; (c) the trend output grows log-linearly between the two points when the actual and trend output are equal. The purpose of the assumption (b) above is to capture the persistent effects of disinflation: output appears to return to its trend with a lag. So the numerator of the sacrifice ratio in (5) is the sum of deviations between the log trend output and log real output. Alternatively, the GDP gap can be calculated using Okun’s Law. That is, one can figure out the unemployment gap (the difference between the real unemployment rate and the natural rate of unemployment) and multiply it by the coefficient of Okun’s Rule to get the GDP gap. But the problem is how to determine the Okun’s Rule coefficient. Many economists have estimated the coefficient of Okun’s Rule and their estimates range from 0.67 to 3.66 (Nourzad & Almaghrbi, 1995-1996). Economists also find the coefficient is subject to change over time. In addition, Okun’s Rule is ineffective in some periods. Therefore, to avoid estimation errors from the coefficient of Okun’s Rule, sacrifice ratios in the paper are calculated by recognizing the trend output directly. Table 3 reports the disinflation episodes and the corresponding sacrifice ratios for the US during 1947:Q1 and 2012:Q2 following Ball (1994). The inflation is calculated based on quarterly data of Consumer Price Index for All Urban Consumers: All Items3. The quarterly data of real GDP are retrieved from the U.S. Bureau of Economic Analysis (BEA)4. The real GDP can exceed the potential GDP, either due to policies or random shocks. This case took place in 1947:Q1–1949:Q1 when the sacrifice ratio is negative. The disinflation 3
Data source: U.S. Department of Labor: Bureau of Labor Statistics at http://research.stlouisfed.org/fred2/categories/9. The index sets 1982-84=100. 4 Data source: http://www.bea.gov/.
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periods 69-71, 73-76, and 79-83 and their corresponding sacrifice ratios reported in Table 3 are close to the calculation in Ball (1994). Actually, we can interpret the sacrifice ratio as the cost of reducing inflation 1% through an aggregate demand contraction only if the demand-side shifts are the major sources of inflation changes. In 1969:Q3–1971:Q3, for example, supply shocks dominate the development of the economy and they affect the sizes of the output losses and changes in inflation. Under such circumstances, the sacrifice ratio is a noisy measure of the effects of demand contractions. But in most disinflation cases reported in Table 3, demand contractions dominated and demand-side policies are the main causes of disinflations. For example, the Federal Reserve actively sought to reduce the inflation rate by contracting money supply from 1980 to 1983. The inflation rate was successfully decreased from 11.50% in 1980 to 3.77% in 1983. Considering the failures of most supply-side policies, economists believe that most supply shocks originate from exogenous impacts (e.g., a change in oil price) rather than policies. Table 3 – Disinflation Periods and the Sacrifice Ratios in the United States Disinflation Period 1947Q1 - 1949Q1 1951Q1 - 1954Q4 1957Q1 - 1963Q2 1969Q3 - 1971Q3 1973Q4 - 1976Q4 1979Q4 - 1983Q3 1989Q3 - 1997Q4 2000Q1 - 2002Q1 2007Q2 - 2009Q3
Length in Quarter 9 16 26 9 13 16 34 9 10
Initial Inflation 8.39% 5.40% 3.36% 5.64% 10.08% 12.50% 5.35% 3.28% 3.83%
Change in Inflation 8.03% 5.45% 2.14% 1.93% 4.06% 9.07% 3.66% 1.48% 3.61%
SR -0.3490 0.8159 2.9957 1.0382 1.2313 1.2368 2.0391 0.2364 0.9067
Even with some misinterpretation, Table 3 shows that the cost of disinflation measured by sacrifice ratio cannot be compensated by its benefits. For example, the benefits of reducing transaction costs by decreasing inflation from its current level (2.19%) to zero are only 0.018%– 0.098% of GDP and the benefits of reducing capital income tax are about 0.044%–0.088% of GDP. These benefits are ten times lower than the costs of shrinking output measured by sacrifice ratios. Therefore, the costs of disinflation are not low enough to be ignored. 2.4.2 Sticky Money Contract The cost of disinflation due to sticky money contract comes from the rigidity of contracts with pre-specified money amounts. Both parties consider the expected inflation when they agree on the money amounts in the contract. Unexpected reduction of inflation is detrimental to debtors. Let us consider an example: someone borrows $1,000 with a commitment to return the 14
principal plus $50 interest a year later. If the expected inflation is 2.5%, when the loan is due, the real amount returned by the borrower is $1,050/(1+2.5%) = $1,024.39. However, due to an unexpected zero-inflation policy, the borrower has to pay the real amount $1,050, a 2.5% higher repayment. Since the money amount was fixed when the contract is signed, the real value of debt increases when the inflation decreases. Of course the losses of the debtors could be transferred to the lenders, but the balance between the parties is broken. This effect is more significant for long-term loans. For example, in a 30-year fixed-rate home mortgage loan, the mortgage rate is fixed when the loan is originated and the rate will be kept the same5 for the entire term of the loan. An unexpected decrease of inflation reduces the level of interest, which encourages mortgagors (borrowers) to prepay the loan. The prepayment risk associated with the early unscheduled repayment of principal increases the uncertainty of mortgagees (lenders) in terms of their interest income and actual maturities of mortgage loans. When principal is repaid earlier than scheduled, future interest payments on that part of the principal will not be paid. So through prepayment, the losses of borrowers are transferred to lenders. No matter whether such transfer exists, an unexpected reduction of inflation will disrupt the balance between two sides in contracts. Labor market faces a similar situation. In a labor contract, an employer determines his employees' salaries based on his expectation of future inflation. On average, the wage level reflects the public's inflation expectation. When inflation drops lower than expected, employers have to keep paying the same salaries (nominal wages) that are now worth more. In other words, real wages would increase and employees would be paid more than they should be. To recoup their lost revenues, employers would cut down production, lay off workers, or simply not hire some workers they would hire otherwise. This would temporarily lower the overall economic welfare. Generally speaking, such costs exist only in the short run. When the disinflation is recognized, new contracts will be written based on a lower inflation expectation. However, even if the cost of money contract rigidity occurs only in transitional periods, it cannot be ignored.
3. The feasibility of Zero Inflation Policy The analysis in Section 2 shows that the costs of zero inflation tend to be higher than its benefits. Even if the total benefits exceed the total costs, the zero inflation policy remains infeasible to implement. I’ll explain the reasons for the infeasibility from the following three 5
If a loan refinancing is not implemented.
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aspects: I. Money Wage rigidity II. Credibility of Central Banks III. Zero Lower Bound of Interest Rates
3.1. Money Wage rigidity The money wage downward rigidity is different from the money contract rigidity we discussed in Section 2.4.2. The money contract rigidity considers transitional effects in the short run, while the wage downward rigidity deals with some psychological issues in the mid-term and long-term. Bewley & Brainard (1993) find that pay cuts are a rare response to decline in sales. They also find that managers are much more fearful of the effects on morale caused by a cut in pay than by a wage freeze. The money wage rigidity is not only a cost of zero inflation, but also the most important reason that the policy is not feasible. Nominal wage reductions are rare. The psychological explanation is that wage reductions are possible only when firms are facing imminent bankruptcy. Any worker receiving a nominal wage reduction would have a right to feel unfairly treated, and firms would be naturally reluctant to reduce money wage, except in very special circumstances. The economic reason for the rarity of wage reductions is poorly coordinated markets. Employers and employees are uncertain about the future price level or nominal wage rate or both. Information is transmitted very slowly, so wages will be adjusted based on changes in price with a lag. Normally the change in wage and change in price expectation are smaller than the change in actual price. Due to the heterogeneities among sectors and industries, high turnover costs could put firms in a bind. For example, if an employer decreases the wages, his employees could leave and find positions in other firms that offer more attractive wages. Therefore in general, employers seldom lower money wage in order to save turnover costs. Because all employers are reluctant to reduce money wage, the downward rigidity forms. We know in the long run the Phillips curve is vertical, but due to the money wage floor it becomes near-horizontal in the downward direction. Therefore, totally eliminating inflation in the long run is impossible or at least accompanied by significant costs. Suppose to lower inflation to zero, the central bank reduces the growth rate of nominal demand to that of the potential demand. Under a lower level of inflation, given the same amount of money wage, the real wage falls at a lower rate than it otherwise would. Besides enduring profit reductions due to 16
the reduction in demands and sales, firms would face a dilemma: either cut the nominal wage (and also the real wage) to make profits but bear high turnover costs, or overpay employees (since the real value of predetermined nominal wage increases) and lose profits. As the inflation approaches zero and the money wage moves close to the real wage, the rigidity will make wage cuts more and more difficult. Firms have to pay a non-decreasing nominal wage whose real value increases with the reduction of inflation, and as a result, short-term unemployment increases. To push down the inflation to zero, policymakers have to sacrifice more output and incur more unemployment than would be the case when the wage is fully flexible. If policymakers insist on doing so, the cost will be significant.
3.2. Credibility of Central Bank The short-run Philips curve illustrates a trade-off between inflation and unemployment. In fact, the Phillips curve shifts over time. Its frequent shifts convince most economists that a trade-off between inflation and unemployment does not exist in the long run. In the short run, the Philips curve can be interpreted as the sacrifice ratio that I discussed in Section 2.4.1. The magnitude of this cost depends on the credibility of central banks. People’s attitude determines the price expectation in the period after the policy is implemented, and in turn affects the levels of unemployment and output. Suppose people’s price expectation P e is a function of the actual nominal price, Pe = p( P), where 0 ≤ p′ ≤ 1 . Based on Branson (1989), we denote the real labor
Pe ⋅ g ( N ) . Therefore, the labor market demand as w = f ( N ) and the real labor supply as w = P equilibrium condition can be expressed in real terms as
f (N ) =
Pe ⋅ g(N ) P
(6)
or in nominal terms as
P ⋅ f ( N ) = Pe ⋅ g ( N ) .
(7)
Assume policymakers use a contractive monetary policy to lower inflation. As the money supply is contracted, nominal interest rates rise, investment falls, consumption falls and net exports fall. Therefore aggregate demand shifts down to the left and in turn the price level falls. When p′ = 0 , the economy is in an immediate run (very short run). The public have Keynesian complete money illusion or simply believe that the decrease of inflation is a random accident. In 17
this case, P e would stay at the level before the monetary policy is implemented. So the nominal e labor supply P ⋅ g ( N ) would remain unchanged while the nominal labor demand P ⋅ f ( N )
would shift to the left (the top left plot in Fig. 2) due to the downward adjustment of actual price level ( P1 < P0 ). Employment would decrease and the nominal wage would fall, which as we discussed in Section 3.1, is hard to realize due to the money wage rigidity. When a short-run or mid-run time period is considered, we have 0 < p′ < 1 . In this case, the expected price would fall but fall less than the actual price ( P1 < P1e < P0e ). Besides the downward movement of the nominal labor demand, the nominal labor supply would shift to the right (the top right plot in Fig. 2). Note that all else the same, a decrease (increase) in price expectation P e makes the nominal labor supply curve Pe ⋅ g ( N ) shift down (up). So in the short run or mid run when the public partially detect the change in actual price and reflect their understanding in the price expectation, the nominal wage ( W ) would decline more, accompanied by a smaller drop in employment. When p′ = 1 in the long run, the public have perfect foresight or are convinced that the government does carry out a disinflation policy. We have P1e = P1 and the “expected” reduction of money supply lowers the price level and nominal wage, but the output and unemployment rate are unaffected (the bottom left plot in Fig. 2). Alternatively, we can analyze the impact of the public’s price expectation on the labor market equilibrium using the real labor demand and supply curves. Use the Keynesian case of complete monetary illusion as an example. As demonstrated in the bottom right plot of Fig. 2, when p′ = 0 , the real labor supply
Pe Pe ⋅ g ( N ) would shift to the left because would go up as P P
P falls and P e remains unchanged. So in the immediate run, the nominal wage would decrease
while the real wage would increase. However, the impact of the contractive monetary policy on aggregate employment is the same whether we analyze the problem using the nominal labor demand/supply (the top left plot in Fig. 2) or the real labor demand/supply (the bottom right plot in Fig. 2). The employment would shrink from N0 to N1 . When 0 < p′ < 1 , the real labor supply would also shift to the left but shift less than when p′ = 0 . In both cases, a lower inflation is achieved by accepting a higher unemployment rate and sacrificing some amount of output. Fuhrer (1994) mentions that “a faster disinflation will cause greater output disruption (other 18
things being equal), while a slower disinflation will yield less output disruption”. Therefore, the sacrifice ratio in the immediate run ( p′ = 0 ) is larger, but the sacrifice ratio in the short run and mid run ( 0 < p′ < 1 ) is still positive. Only in the long run when p′ = 1 can the sacrifice ratio be close to zero. Fig. 2. Impact of a contractive monetary policy on the labor market equilibrium Case 0
