Should The Central Bank Aim For Zero Inflation

One of the Ten Principles of Economics discusscd in Chapter l,and developed more fully in the chapter on money growth and inflation, is that prices rise when the government prints too much money. Another of the Ten Principles of Economics discussed in Chapter 1, and developed more fully In the preceding chapter, is th.it society faces a short-run trade-off between inflation and unemployment. Put together, these two principles raise a question for policymakers: How much inflation should the central bank be willing to tolerate? Our third debate is whether zero is the right target for the inflation rale.

Pro: The Central Bank Should Aim for Zero Inflation

Inflation confers no benefit on society, but it imposes several real costs. As we have discussed, economists have identified six costs of inflation:

• Shoeleather costs associated with reduced money holdings

• Menu costs associated with more frequent adjustment of prices

• I ncreased variabilily of relative p rices

• Unintended changes in tax liabilities due to nonindexalion of the lax code

• Confusion and inconvenience resulting from a changing unit of account

• Arbitrary redistributions of wealth associated with dollar-denominated debts

Some economists argue that these costs are small, at least for moderate rates of inflation, such as the 3 percent inflation experienced in the United Slates during the 1990s and early 2000s. Hut olher economists cbim these costs can be substantial, even for moderate inflation. Moreover, there b no doubt that the public dislikes inflation. When inflation heats up, opinion polls identify inflation as one of the nation's leading problems.

The benefits of zero inflation liave to be weighed against the costs of achieving it. Reducing inflation usually requires a period of high unemployment and low output, as illustrated by the short-run Phillips curve. But this dbinflationary recession b only temporary. Once people come to understand that policymakers are aiming for zero inflation, expectations of inflation will fall, and the short-run tr.Kle-off will improve. Bccause expectations adjust, there b no trade-off between inflatkin and unemployment in the king run.

Reducing inflation b. therefore, a policy with temporary exists and permanent benefits. Once the dbinflationary recession b over, the benefits of zero inflation would persbt into the future. If policymakers are farsighted, they should be willing to incur the temporary costs for the permanent benefits. Thb b precisely the calculation made by Paul Volcker in the early 1980s, when he tightened monetary policy and reduced inflation from about 10 percent in 19)*) to about 4 percent in 19&3. Although in 1982 unemployment reached its highest level since the Great Depression, the economy eventually recovered from the recession, leaving a legacy of low inflation. Today, Volcker is considered a hero among central bankers.

Moreover, the costs of reducing inflation need not be as large as some econ-ombts claim. If the Fed announces a credible commitment to zero inflalkm, it can directly influence expectations of inflation. Such a change in expectations can improve the short-run trade-off between inflation and unemployment, allowing the economy to reach lower inflation at a reduced cost. The key to this strategy b credibility: People must believe lhat the Fed b actually going to carry thmugh on its announced policy. Congress could help in thb regard by passing legblation that made price stability the Fed's primary goal. Such a law would make it less costly to achieve zero inflation without reducing any of the resulting benefits.

One advantage of a zero-inflation target is thai zero provides a more natural focal point for policymakers than any other number. Suppose, for instance, that the Fed were to announce that it would keep inflation at 3 percent—the rate experienced during much of the previous two decades. Would the Fed really stkk to that 3 percent target' If events inadvertently pushed inflation up to 4 or 5 percent, why wouldn't it just raise the target? There is, after all, nothing special about the number 3. By contrast, zero is the only number for the inflation rate at which the Fed can claim that it achieved price stability and fully eliminated the costs of inflation.

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