RDP 1999-08: Inflation Targeting and Output Stabilisation 3. Inflation and Output Variability

The objective function in Equation (3) implies that stabilisation of inflation and output is an appropriate goal for policy. The objective function is however, only a shorthand way of making practical the policy-maker's ultimate aim which is to maximise welfare. This raises the question of why variability of output and inflation is detrimental to welfare.

Why should output variability be of concern to the policy-maker? Schumpeter has raised the possibility that some degree of output variability may indeed be beneficial. More recently, this has been characterised as the ‘cleansing effects of recessions’ (Caballero and Hammour 1991). Countering this argument, if there is convexity in the Phillips curve, there is a negative interrelationship between the variability of output and level of output. The greater the variability of output, the lower the average level of output (through a simple application of Jensen's inequality). A growing body of evidence suggests that there may indeed be convexity in the short-run Phillips curve.^[4] Moreover, it would appear that large recessions are particularly costly and hence, should be avoided where possible.

Why should inflation variability be of concern? Excessive inflation variability reduces the credibility of policy-making, as will be discussed further below. The loss of credibility may be reflected in a drift upwards in inflation expectations above the targeted rate, which in turn will increase the costs of bringing inflation back to target. There is also substantial empirical evidence of a positive relationship between inflation variability and the level of inflation.^[5] If higher inflation variability leads to higher average inflation, this will be detrimental to the long-run performance of the economy.

A variable inflation rate also reduces the predictability of future prices, thereby increasing the costs of writing long-term contracts. A price-level target would decrease these costs even further than an inflation target, although no central bank has adopted such a regime at this stage.

The trade-off between output and inflation variability also effects the monetary policy strategy in a disinflation. Ball (1994) presents some evidence that the sacrifice ratio may be lower in faster disinflations. Thus, output variance would be lower in a more rapid disinflation. This, however, runs counter to the evidence on convex Phillips curve which suggests that deep recessions are excessively costly and do not provide much added disinflationary impetus.

Finally, while the above discussion has focused on the variability trade-off, the cross-country empirical evidence suggests that there is a positive relationship between output and inflation variability (Debelle and Fischer 1994). However, this result most likely reflects the general competence of policy-making: countries which have unsound policy regimes are likely to generate both higher inflation variability and output variability. The evidence from within individual countries based on simulations of small estimated macroeconomic models, which is summarised in the next section, clearly demonstrates the negative relationship.

Footnotes

See Debelle and Laxton (1997) and the references therein. [4]

However, as Ball (1993) illustrates, this again may be another manifestation of lack of policy-making credibility. In response to the higher inflation, the policy-maker attempts (ultimately unsuccessfully) to cause a disinflation. These frequent transitions between high and low inflation rates increases the variability of inflation. [5]