Friday, August 20, 2010

A daft form of stimulus: deliberately stoking inflation.

One of the most fatuous forms of stimulus ever advocated is the idea that a central bank should announce a higher inflation target (advocated for example by Mark Thoma). The big idea is that given higher inflation, the private sector will try to dispose of cash, which in turn will raise demand and reduce unemployment. Also, at the current zero or near zero interest rates, higher inflation means an effective drop in interest rates which ought to have a stimulatory effect.

The above idea certainly ought to work, but there are serious problems with it. That is, there are better forms of stimulus.

The first problem is the question as to how big an effect a mere announcement by a central bank is. If the mere announcement that inflation will be X% in Y years’ time makes it so, then this is news to the world’s central banks. No doubt they dearly wish they had that measure of control over inflation. (Though arguably it is easier to talk up inflation than talk it down.)

As distinct from mere announcements, the really effective way of raising inflation is to do something which is well known to raise inflation, e.g. effect a big rise in demand, for example by lowering interest rates too much or printing and spending too much extra money.

But this works primarily (or only) to the extent that demand becomes excessive. And the ultimate purpose of the “high inflation target idea” is to raise demand and reduce unemployment! So what’s the point of the “high inflation”, given that the only or main way that the high inflation policy works (raising demand) is itself the solution to the problem?

The second big drawback with “inflation increasing” is that inflation is notoriously difficult to control compared to other methods of influencing demand. For example it took best part of a decade to get the excessive inflation of the 1970s and 80s under control. That is far too long a time span for dealing with recessions and inflationary booms. A vastly better method of influencing demand is the standard Modern Monetary Theory one: just alter taxes or one or more of the various forms of government spending.

The only delay involved in the two latter is the time taken by bureaucrats to get a move on, and DO IT. For example, the U.K. adjusted its sales tax (VAT) downwards on 1st December 2008 and then up again thirteen months later.

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