What is the point of a constant (thus known) inflation rate?

Question

I have read somewhere (attributed to Milton Friedman) that a good practice of monetary policy is to maintain a constant inflation rate (of 3% per annum, say). What is the point of that? If everyone knows the constant inflation rate, would they not factor that in when pricing goods and thereby effectively eliminate the inflation?

As a toy example, suppose the Feb maintains the money supply $M(t)=M(0)e^{at}$ at time $t$ for some constant $a$ known to people. Then people will price the goods (including debts) $P(t)=P(0)e^{at}$ at time $t$ where $P:=(p_1,p_2,\cdots,p_n)$ is a vector of prices for $n$ goods. Then the ratio of the prices $P/p(1)=(1,\frac{p_2}{p_1},\cdots,\frac{p_n}{p_1})$ remains the same. What is the point of the targeted inflation?

I can think of one justification in a particular scenario for setting a target but of the money supply rather than of inflation which is the increment in price. If we know the quantity, so to speak, of the economy is growing at $Q(t)=Q(0)e^{at}$. Then it makes sense to increase the money supply as described above, so that people can still price the goods at $P(t)=P(0)$. But this is no price inflation. Besides, if the money supply is held constant and the quantity grow rate is known, people can just price the goods at $P(t)=P(0)e^{-at}$ and the price ratio still remains unchanged. I do not see the harm in price deflation.

The possible flaw in this setup is that the "speed" of the diffusion of the physical monetary supply amongst the non-bank entities is no greater than the "speed" of the transaction. We can eliminate this flaw and achieve infinite monetary diffusion speed and simultaneity of inflation by bringing all transactions onto digital platforms. People can set their algorithms to increase the prices at the target rate.

This question is related but different from the question Is zero inflation desirable?. The latter asked about the effect of keeping inflation at zero. My question asks whether targetting an inflation rate not necessarily zero that is to be known to all people is any different from zero inflation and its desirability.

Answer 1

As I understand it, your question is the following:

Assuming that the rate is inflation is known by all in advance, does it matter what rate of inflation we set?

The answer to this question is 'yes'. For one thing, even if inflation is predictable, it transfers resources from holders of cash to the government or monetary authority ('seigniorage'). As a result, people may try to hold less cash, which means they need make more trips to the bank (leading to 'shoe leather costs').

Thus, contrary to the supposed lesson of your 'toy model', perfectly predictable inflation can have real effects.

However, you are right to emphasise that the importance of predictability: unpredicted inflation often has effects that predicted inflation does not. For example, consider the common claim that an increase in inflation is good for borrowers and bad for lenders. If unpredicted, that is certainly true. But if predicted by all in advance, one might expect the increase to simply drive up nominal interest rates, leaving the real interest rate unchanged.

Answer 2

First, contra to your last statement, deflation is obviously harmful if one considers its effect on growth via demand:

The nominal interest rate cannot fall below zero, because that would mean reducing savers’ bank balances every month, and would prompt them to withdraw their deposits from banks and stash cash under the bed. Together with inflation, this puts a floor on the real interest rate too. If inflation is low and real rates can’t fall far enough to boost demand and perk up prices, demand will weaken still further. This is the dreaded deflation trap.

What you're missing from your model is any notion of savings and interest. There's also the psychological issue of cutting wages in nominal terms to keep up with deflation. (As an aside, that's also one of the reasons why laying off people is preferred to wage cuts in a downturn.) I'm sure there are more questions here on econ.SE about deflation.

Second, the real answer to your question (targeting a non-zero inflation) is price stability. To quote your an ECB paper:

We are interested in finding the price index [i.e. inflation] that, if kept on an assigned target, would lead to the greatest stability in economic activity. This concept might be called the stability price index.

Constructing the latter is pretty complicated in a multi-sectoral model, and you're invited to read ECB's paper. But avoiding deflation is one of the goals:

Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability. This aim also underlines the ECB’s commitment to provide an adequate margin to reduce the risks of deflation. Having such a safety margin against deflation is important because there are limits to how far interest rates can be cut. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.

As for why some arbitrary number >>0 for inflation decreases economic stability... that is slightly more involved to answer in modelling terms, I won't attempt that here. A highly cited empirical paper by Barro (1995) found that when high-inflation is included in the sample growth is negatively affected:

Data for around 100 countries from 1960 to 1990 are used to assess the effects of inflation on economic performance. If a number of country characteristics are held constant, then regression results indicate that the impact effects from an increase in average inflation by 10 percentage points per year are a reduction of the growth rate of real per capita GDP by 0.2-0.3 percentage points per year and a decrease in the ratio of investment to GDP by 0.4-0.6 percentage points. Since the statistical procedures use plausible instruments for inflation, there is some reason to believe that these relations reflect causal influences from inflation to growth and investment. However, statistically significant results emerge only when high- inflation experiences are included in the sample. Although the adverse influence of inflation on growth looks small, the long-term effects on standards of living are substantial. For example, a shift in monetary policy that raises the long-term average inflation rate by 10 percentage points per year is estimated to lower the level of real GDP after 30 years by 4-7%, more than enough to justify a strong interest in price stability.

Another observed fact from high[er]-inflation periods that has some explantory power is that higher inflation reduces the performance distinction between stocks and bonds (thus lowering the attraction to invest in more growth-producing assets):

By contrast, when inflation is higher and more volatile— as it was in the 1970s [US] —the correlation between stocks and bonds increases. Because rising inflation negatively affects the performance of both stocks and bonds, bonds generally become more equity-like amid higher inflation and thus tend to provide less diversification.

In theory one might be able to come up with a model where high but stable inflation exists (you actually did that), which might cause stocks and bonds to behave differently [enough], but in practice such historical examples of high but non-volatile inflation are rather lacking.

The textbook problems with high level of inflation (not taking volatility into account):

• "shoe-leather" cost: keeping lower money balances when inflation is high (implying more frequent trips to the bank/ATM).
• menu cost: time and effort to change price lists in an inflationary environment

I'm not sure how well-tested these are in practice (as distinct effects).

On top of those level effects (which are disputed by some economists), volatility in inflation brings its own problems:

E.g. an ECB paper stating these as well-known facts:

Among the harmful effects of inflation, the negative consequences of inflation volatility are of particular concern. These include higher risk premia, hedging costs and unforeseen redistribution of wealth.

Or another empirical paper actually evaluating the effect of inflation volatility (separately from level):

This paper re‐examines the relationship between inflation, inflation volatility and growth, using cross‐country panel data for the past 30 years. With regard to the level of inflation, we find that exploiting the time dimension of the data reveals a strong negative correlation between inflation and income growth for all but low inflation countries. To examine the role of inflation uncertainty on growth, we use intra‐year inflation data to construct an annual measure of inflation volatility. Using this measure, we find that inflation volatility is also robustly negatively correlated with growth, even after the effect of the level of inflation is controlled for.

As far as I know far fewer economists disagree with the latter points, i.e. that volatility of inflation is bad (for growth). E.g.:

While the level of inflation was found not to have a significant effect on growth, [...] inflation volatility does significantly impact growth even for countries with moderately high levels on inflation.

There are also works that discuss whether/why inflation uncertainty rises with the inflation level, i.e. even if you don't have actual volatiliy of inflation, a perception of an increased risk of volatiliy may be enough to create negative effects associated with volatility.

While the costs of inflation uncertainty are relatively easy to identify, explaining why inflation uncertainty increases with inflation is more difficult. The most appealing explanation involves the response of monetary policy to inflation. When inflation is low, monetary policymakers try to keep it low. To the extent they are successful, inflation remains low and stable. When inflation is high, however, monetary policymakers are more likely to adopt disinflationary policies. These policies, by lowering the inflation rate, increase inflation variability. Moreover, the policies create inflation uncertainty because the timing and short-run impact of policy on inflation are uncertain.

Basically it is a learned effect from what central banks usually do.

Answer 3

So in your question is basically two questions, right. Firstly, why target constant inflation, and why not just zero?

The first question about the constancy of the inflation rate. Basically it ensures stability of the real economy if future inflation is known within some interval. An example hereof is contracts, which are much easier to write if the inflation is pretty stable. Even more importantly financial system will tend to work better and fund projects which are beneficial.

Why can't inflation just be zero? Firstly a lot of debt is created constantly in society. Inflation has traditionally been a valve to lower the real burden of debt over time. Secondly, the economy tend to experience inflation, because prices change when the economy experiences pressure. Thus, it would be hard for any central bank to target zero inflation. Lastly, changing prices tend to smooth changes in the economy. In other words, changing prices provide dynamism in e.g. wage negotiations and other things.

I am sure there are other reasons for both question, but these were the ones that sprang to mind.

Answer 4

In addition to the reasons given by pkpkPPkafa, an important reason to target a non-zero inflation rate is to reduce the lower bound of real interest rates. There is commonly perceived to be a zero nominal lower bound for interest on most forms of debt. If inflation is at (say) 3%, then an interest rate of (say) 0.5% creates a negative real interest rate, enabling the central bank/government to pursue a more stimulating monetary policy than would otherwise be possible.

Being caught by the zero lower bound of nominal interest rates is often referred to as a "liquidity trap". Paul Krugman has written extensively on this, particularly with reference to Japan.

Answer 5

Just to add to the other answers here:

A constant rate is desirable because in general, information flow is not instantaneous, and delays in information flow in dynamical systems lead to oscillations. Friedman's point about the desirability of a constant inflation rate could be understood as a point about oscillations - an oscillating inflation rate necessarily produces time-arbitration opportunities, leading to oscillations in consumption and savings behavior that are detached from fundamentals.

The rate of inflation acts as a brake on economic growth. The goal is to produce a "critically damped" system that grows as fast as possible while minimizing oscillations around its steady state (in the Solow model, this is the "golden steady state"). In this context, a zero inflation rate implies perfect and instantaneous information flow to all agents in the economy - but in a world where price-setting is an emergent (read: market-based) process and menu costs are a thing, this is not a realistic scenario.