Essay: Discuss whether the primary macro economic target of the govt should be low inflation

The govt has given the MPC an inflation target of CPI 2% +/-1. Therefore, Monetary policy is primarily designed in order to achieve this goal.

There are many benefits of low inflation. Firstly, if inflation is low and stable firms will be more confident and optimistic to invest. This will lead to an increase in LRAS and enable higher rates of economic growth in the future. Also, if the govt is committed to keeping inflation within a certain target this may help inflation expectations be low.

If inflation is allowed to increase because Monetary policy is too lax, there could be an economic boom, but if this is above the long run trend rate of growth this is likely to be unsustainable and the boom will be followed by a bust (recession) This occurred in the UK in 1991, after the Lawson boom of the 1980s. Therefore, maintaining low inflation will help avoid cyclical fluctuations in the economy which can cause negative growth and unemployment.

High inflation has other costs such as menu costs. This is the cost of changing price lists. If inflation in the UK is higher than elsewhere UK goods will become uncompetitive causing a fall in exports, and possibly a deterioration in the current account of the balance of payments.

Monetarists believe that inflation can be reduced without conflicting with other macroeconomic objectives. This is because they believe that the LRAS in inelastic, therefore a fall in AD will only cause a temporary fall in Real GDP, but after a short period the economy will return to the full employment level of National Output.

Therefore the govt should not worry about a temporary rise in unemployment as a result of tight monetary policy because the economy will soon return to equilibrium at Yf.

However, this view is not shared by all economists. Keynesians argue that the economy can be below full capacity for a long time. To keep inflation within its target it may be necessary to have a significant tightening of monetary policy which could cause a recession.

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The above diagram shows a fall in inflation as a result of higher interest rates; however, it has caused a fall in AD and lower Real GDP. Keynesians argue that the economy may take a long time to recover because the negative multiplier effect will magnify any fall in AD. Also, if confidence is low consumers may be reluctant to spend.

The experience of Japan in the 1990s shows that low inflation can cause many serious economic problems. Inflation has been very low, but Japan has suffered from growth far below its long term average and has seen unemployment rise. Rising unemployment has many serious costs such as increased inequality, higher govt borrowing and a rise in social problems. In this case economic growth is arguably a more important objective even if it conflicts with higher inflation.

Inflation is more likely to conflict with unemployment if there was a supply side shock, such as, lower productivity or an increase in the price of commodities. In this case to keep inflation low would need a very tight Monetary policy and a recession may be quite likely.

In conclusion, low inflation has many benefits which help improve the economic performance of the economy such as increased investment. Also it is possible to have low inflation and low unemployment which suggests the Phillips curve trade off is not necessarily always right.

However, in some circumstances keeping inflation low may be unsuitable for the economy. If there was a supply side shock to the economy keeping to the inflation target may cause increased unemployment and lower growth which is very undesirable. Therefore the govt should perhaps aim for low inflation but have a degree of flexibility if this appears unsuitable to the current economic climate.

By on November 28th, 2012 in