Readers Question: suppose you are the governor of the bank of Canada .. and that inflation has been high and roughly constant for a number of years. you have two policy choices: you can attempt to eliminate the sustained inflation. Outline the issues involved when making this choice. list and explain the costs of ongoing inflation, and also the costs of a potential disinflation. explain how you make your policy decision.
There is only one choice in this question – eliminate sustained inflation. I guess the alternative is to allow the inflation to continue and target higher economic growth.
Costs of Inflation
If Canada has high and sustained inflation it will have the following costs:
- Discourages investment. High levels of inflation create uncertainty and lead to lower investment levels. Countries with higher inflation rates tend to have lower rates of economic growth in the long term.
- Falling International Competitiveness. If Canada has a high rate of inflation then it is likely that they will be losing international competitiveness. This will cause lower exports and potentially higher unemployment.
- Menu costs / Shoe leather Costs. These may not be too high in a modern economy, but, they involve the costs of changing price lists and looking for the best-valued prices.
See: costs of inflation
Therefore these costs suggest there is a good reason for the Bank of Canada to use monetary policy to try and reduce inflationary pressures. This will involve increasing interest rates. Higher interest rates will
- Make borrowing more expensive
- Reduce the disposable income of those with mortgages
- Make saving more attractive
- Lead to an appreciation in the Canadian currency (because of attracting hot money flows)
This has the effect of reducing investment, consumer spending, AD and economic growth. This will reduce inflation but at the cost of lower growth, higher unemployment and possibly a recession. The slowdown in growth will also lead to higher government borrowing because people will pay lower tax and the government spend more on benefits.
Exporters will be adversely affected by the rise in the exchange rates as it makes exports less competitive.
The only benefit is that it will improve the current account because it reduces import spending.
Short Run vs Long Run
Therefore in the short run, reducing inflation has visible costs of lower growth and higher unemployment. However, it is argued this will only be a short term fall in growth. Once inflation has fallen, the bank can reduce interest rates and then the economy can grow with low inflation.
Hysteresis
This is the idea that inflation depends on inflation in the previous year. If inflation is constantly high then it tends to be high in the future because this is what people expect. However, if the Bank reduce inflation and convince markets they are serious about reducing inflation, people will expect low inflation in the future. Therefore, a one off painful reduction in inflation may be worth it in the long term.
Questions to Bear in Mind
- How High will Interest rates have to rise to reduce inflationary pressure?
- Are there any alternatives to reducing inflation e.g. supply-side policies may be able to reduce wage inflation.
- What is the state of the economy? If the economy is near full capacity you may be able to reduce growth without causing too much hardship.
- Time Lag of interest rate rises
- The UK has had a positive experience since reducing inflation in the early 1990s.
- China has preferred to have high inflation and high growth. Inflation is currently 8%, and they haven’t put much emphasis on trying to reduce it.
Should Government have objective of Low inflation?