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The buffer also helps to ensure that the economy

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Unformatted text preview: rgue that the optimal inflation rate would vary depending on the type of shocks to the economy. Hayami (2000a) basically argued that a desirable inflation rate varies from country to country, and it was probably lower in Japan than other countries. He provided two reasons for this. First, deflation in Japan reflected supply-side shocks, and when such shocks lead to lower prices, deflation may be desirable. Second, since wages are flexible in Japan, output losses la Akerlof et al (1996) would be small. Moreover, in terms of the lower end of the range acting as a buffer against deflation, Hayami (2000a) stated that [t]he idea of tolerating a certain positive rate 33. Until December 2003, the target rate was 2.5 per cent, based on the retail prices index excluding mortgage interest payments (RPIX). Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 249 of inflation to ensure a cushion for monetary policy seems to be something like putting the cart before the horse. On 13 October 2000, two months after raising interest rates, the Policy Board issued a report called On price stability. In the document, price stability was defined as a state that is neither deflation nor inflation. The document did not mention any numerical number that would define deflation or inflation, and as a consequence, price stability. The debate moved to a new phase on 19 March 2001, since a zero per cent inflation rate was mentioned as a necessary condition to terminate the ZIRP. It seems that the Bank of Japan still regards a zero per cent inflation rate as price stability, but mentioning a particular number was still a sign of some progress. However, while the Bank of Japan still prefers zero per cent as a magic number, other central banks are moving away from zero per cent, precisely due to the buffer argument. New Zealand revised its target range from 0 to 3 per cent to 1 to 3 per cent in September 2002. 3.4.4 Inflation targeting in deflation is unprecedented Another popular argument against inflation targeting was that no country had adopted inflation targeting to return to inflation from a state of deflation.34 However, no other major country has faced sustained deflation in the post-war period. As such, the fact that no country has done it is not a valid argument against the proposal. During the Depression of the 1930s, many countries suffered from deflation. Sweden adopted a kind of inflation targeting (to be precise, price-level targeting) when it departed from the Gold Standard, in an attempt to use a nominal anchor to avoid deflation (see Berg and Jonung 1999). 3.4.5 Announcement alone will not be credible It is often argued that the mere announcement of an inflation target would not change expectations.35 In response, advocates of inflation targeting would contend that, although expectations are the most important and unique channel of inflation targeting, the effects may not be immediate. Having a target, in combination with the use of other measures, such as some degree of unconventional monetary policy, would certainly raise the probability of anchoring expectations faster than otherwise. The loss of credibility if the inflation target was not achieved often referred to by the Bank economists and Board members has to be balanced against the loss of credibility by not forcibly acting on the deflation problem. It is certainly true that a mere announcement would not significantly change the publics inflation expectations. The introduction of inflation targets among advanced countries tends to be accompanied by an institutional framework that makes inflation targeting credible and accountable. In several countries, including New Zealand and 34. The view was expressed in the MPM on 21 January 2003; see the Appendix. 35. The view was expressed in the MPM on 12 January 2001; see the Appendix. 250 Takatoshi Ito Australia, inflation targeting is an agreement between the government (typically the Ministry of Finance or Treasury) and the central bank, and both are committed to policy that is consistent with the inflation target. In several countries, including New Zealand and the UK, when inflation exceeds the target by a wide margin, the Governor is required to provide an explanation to the parliament. With accountability and commitment, inflation targeting does become credible. 3.4.6 The long-term interest rate will go up Another argument against inflation targeting is based on the possibility that inflation targeting could be instantly believed the opposite scenario to the preceding point. If the public believes in the inflation target of, say, 2 per cent, then the longterm interest rate would increase by 2 per cent, before the economy recovers, which would damage the economy.36 Since the long-term interest rate is a compound of future (expected) short-term rates, a belief that inflation targeting would lead to an average 2 per cent inflation rate would raise the long-term interest rate. However, if the amount of a rise in the nominal interest rate is less than the amount of a rise in inflation expectations, then the real long-term rate will fall. Therefore, t...
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