Fluctuating Inflations and Zero Inflation - Assignment Example

Inflation Name: Institution: Date: Question one Inflation isa rise in price levels over a specified period of time. It’s the percentage change in the price level from one period of time to the next and varies from country to country [EUC09].Inflation targeting therefore involves the central bank setting a projected rate which it then tries to achieve through the use of interest rates andvarious monetary tools. It’s is executed using 5 major steps which include;1) public announcement of forward-looking medium-term numerical targets for inflation; 2) an institutional commitment to price stability as the primary, long-run goal of monetary policy and to achievement of the inflation goal; 3) an information inclusive strategy; 4) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers; and 5) increased accountability of the central bank for attaining its inflation objectives.[Fre04]. It has proven to have the following social advantages: i. It’s not myopic which translates into it using all the available information provided in setting policy instruments which focuses on the long run price stability achievement. ii. It’s readily comprehended by people consequently highly transparent. This makes the communication between the government involved, citizens and the markets. Consequently, future market volatility declines due to a decrease in uncertaintyin the future monetary macroeconomic policy movements.[Fre04]. iii. In adition, ithas the potential to control political debate in a country on what the central banks can do (inflation control), instead of based on that which they cannot alter(Permanentrise in economic development and growth). An advantage of this is a reduction in instances where banks use overly expansionary monetary and fiscal policies to increase output and employment level in the shortrun, and focusing on long-term strategies on macroeconomic stabilization iv. Inflation targeting in any country is usually consistent with the democratic principles, finally it increases transparency and bank accountability. Despite several positive outcomes, inflation-targeting has its some prominent disadvantages which include the aspect of not defining the future trail of prices, consequently resulting in pricey improbability in the macroeconomic.[Col08]. Fluctuating inflations has the following social costs Uncertainty in Purchasing Power This affects consumers with a fixed income levels. Fluctuating inflation results to fluctuating real money balance available to a consumer even with an increase in nominal value. This causes the purchasing power parity to fluctuate as well. Uncertainty of future prices which complicates the current economic policies and decisions A fluctuating inflation rate may affect the competitiveness of local firms against the international trade partners when it causes uncertainty in price levels. An uncertain trade partnership is not good for sustainable economic growth of a country. Price level uncertainty may also affect private consumption levels. Since private consumption is a contributor to aggregate demand of a country, instability in the value brings adverse effects to the GDP growth. Future value fluctuations are also unanticipated in such an economy, Lenders won’t lend and Producers won’t produce in uncertain markets[Jus14]. There will be a lag between producers raising prices in the market place and incomes of purchasers being raised. [Jus14]. Question two By avoiding fluctuations in output and employment stability is achieved which avoids recessionary and inflationary effects in the business cycle subsequently avoiding uncertainties and disruptions in the economy. As a result of all these, factors of production can strategize in a long-term span and consumers too can have long-term consumption plans. According to Keynesian theory of employment, he argues that when there is not effective demand, unemployment level rises due to decrease in employed population. A fluctuation the level of aggregate demand determines the natural output level. This is also the point where employment in the economy is at full employment level. Also known as full unemployment level that happens in the long run adjustment between output and inflation thus employment level too. This can be graphically illustrated as below: Fluctuating output and employment implies that it can be a decrease or an increase. An increase in output level increases aggregate demand. This pushes prices upwards which results to inflationary effects in the long run. A decrease in output level reduces short run supply pushing prices upwards as well due to excess demand. Consequently, firms are forced to lay of some of the workers to stay afloat and breakeven which increases unemployment level decreasing social standards of the laid off consumers. One of the major goals of output and employment level stabilization is a reduction in inflationary effects thus reducing poverty levels which are macro-economic issues. In conclusion, the cost of inflation reduction in regards to employment and output losses is provisional to Real rigidities in the goods and labor markets, nominal rigidities in the formation of inflation expectations, the stance of monetary and fiscal policy and the initial level of inflation[Kar14]. The factors that contribute to magnitude of the welfare cost in an unstable econmy?[Sor10] Returns to scale Demand elasticity parameters- Savings preference-The higher the tendency of consumers to save wealth in form of cash, especiallyretirees, the higher the costs of inflation The return on capital The capital income tax Question three There is also a broad consensus that high, volatile and unanticipated inflation induces large costs. However, it is a remarkable result of research activities in the past decade that even low, steady and anticipated inflation creates substantial welfare losses.[Kar14] A constant rate of inflation implies that the economic growth is also constant and the economic status of the country worsening with time compared to its trading partners. This will lead to slow economic development as well with little change in employment level. The country will also have no external supply shocks. However, even if the consumers get certainty of the value of money now, they may expect it to rise in future using rational expectations theory rationale. Producers will start social ills such as hoarding creating artificial shortages in the hope that the price level will go up in future. This will slowly push prices upwardseventually in a correctly anticipated model. If the consumers and producers take the price level as given, welfare costs that may arise includes a decline in employment level compared to the total active labor force, slow consumption pattern path and slow investments translating into poor economic growth. Factors that policy makers take into account when before choosing a P.I[Sor10] Price index is a measure of consumer’s standard and cost of living at a particular time based on the economy’sinflations. It’stherefore used as a measure of inflation. Policy makers should select a target price index that is easily understood by the public to ensure effectiveness while acting as a guide to inflation expectation ns of the public.A good target CPI should exclude basket commodities with volatile prices to best describeinflation trend as well as demand pressures. They should also consider the inflation target level that is prevailing in the country. Consumers whose main source of income is fixed are more vulnerable to changes in price levels compared to ones whose income is not affected by interest level changes in the country. Policy makers should therefore consider effect of inflation variance based on the majority consumer’s income sources to avoid fluctuations and affecting their net worth when hit by fluctuating inflation levels. Hence setting an inflation target at a high level will cause various prices in the economy to become more uncertain affecting private consumption, investment plans and decisions eventually affecting economic growth.[Ban09]. Another yet crucial factor is time horizon based on inflation target range. CPI is directly linked to an inflation target; consequently any factor that affects inflation targeting affects the CPI level. The shorter the time period, the more the public puts confidence in its central bank to stabilize inflation rate that goes beyond the targeted level to ensure purchasing power is not affected adversely. Is zero inflation an optimal inflation target?[Sor10] According to (Konieczy, 1994), he suggested that zero inflation ratesare the optimal one due to price stability considerations which improves price mechanismtransparency. The argument is that people are able to recognize changes in relative prices without being confused by changes in the overall price level.[Kar14]. Zero inflation is thus optimal since it’s a positive value and according to Friedman, unless alternative tax denoted by lamder equals zero, a deflation will always be optimal. Australia uses inflation targeting policies to keep their inflation levels at recommended level. They however are always trying to keep it above zero. This is because zero inflation is hard to be attained unlike any other level. It has been the FEDS primary goal according to most economists due to reduction in price levels uncertainty, absence of negative supply shocks and ease of implementing government policies for macroeconomic stability. However, it’s associated with low GDP levels which intern results to low investment output consequently slow economic growth. A little inflation is required to stimulate the economy upwards and create room for innovations for better economic growth. In extreme cases it is even conceivable that the economy enters a deflationary spiral due to costs that would arise because monetary policy would partly forego its power to counteract large deflationary shocks since nominal (and therefore real) interest rates could not be cut further once the zero bound is reached[Kar14]. Question four Over recent years, policymaking institutions, including the European Central Bank (ECB) and the National Central Banks (NCBs) within the European System of Central Banks (ESCB), have given increasing emphasis to measures of potential output and the associated output gaps, both in the macroeconomic projections and in the assessment of the monetary policy stance.[Igo11]. Trend level of output is equal to the sequence of permanent (unit-root) stochastic technology shocks that characterize the stochastic balanced-growth path of the model [Igo11]; the corresponding output gap (equal to actual output less trend output) measures thebusiness cycle component of output;[Igo11] thus, it is closely related to more traditional measures of the output gap.[Igo11]. This concept is long run oriented due to its fluctuations only attributable to technology shocks ignoring the steady state fluctuations. Unlike the previous concept obtained using modernmeasures, thisuses more conventional ways. Forinstance, the famous Hodrick-Prescott Filter. Efficient level of output on the other hand is the level of output that would prevail under flexible prices and wages and imperfectly competitive markets (so, differently from the efficient output, steady-state mark-up and mark-up shocks are different from zero); the related gap measures only the relevance of nominal rigidities.[Igo11]. This concept has a business cycle dimension unlike the latter. The business cycles are attributable to both permanent and transitory structural shocks which push the economy away from the trend output level reflecting perfect competition. For monetary policy conduct, policy makers should consider the output gap between efficient level and the natural output which is directly proportional to the major accelerator of inflation. I.e.the real marginal cost. The relevance of natural and efficient output concepts for a normative assessment of monetary policy gives rise to two case scenarios which are ‘divine coincidence’ and one where efficient and natural outputs are no longer proportional due to exogenous markup shocks that introduce a tradeoff between stabilizing inflation and efficient output.[Igo11]. References EUC09: , (EUCE North Caroline, 2009, p. para.2), Fre04: , (Frederic S. Mishkin, Jan 2004, p. 5), Fre04: , (Frederic S. Mishkin, Jan 2004), Col08: , (Coletti Donald, 2007-2008, p. 1), Jus14: , (Just anwer, 2003-2014, p. para 12), Jus14: , (Just anwer, 2003-2014, p. para16), Kar14: , (Karl-Heinz Tödter, 2014, p. 47), Sor10: , (Jacobsen, 2010), Kar14: , (Karl-Heinz Tödter, 2014, p. 53), Ban09: , (Bank of Thailand Report, 2009, p. 2), Kar14: , (Karl-Heinz Tödter, 2014, p. 19), Kar14: , (Karl-Heinz Tödter, 2014, p. 48), Igo11: , (Igor Vetlov, June 2011, p. 9), Igo11: , (Igor Vetlov, June 2011, p. 10), Igo11: , (Igor Vetlov, June 2011, p. 10), Igo11: , (Igor Vetlov, June 2011, p. 11), Igo11: , (Igor Vetlov, June 2011, p. 12), Read More