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No NONSENSE

Expectations and monetary policy

Back in 1968, Nobel Laureate economist Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the expense of "just a little more" inflation. He predicted that people would come to anticipate that extra inflation and then would change their behaviour in various ways.

Abdullah A. Dewan
UNDERSTANDING the economic processes that generate inflation has been an important, yet elusive, objective for macroeconomists and monetary policy authorities One piece of the puzzle is the role of inflation expectations (INFEXP) in the inflation generating process.
INFEXPs affect interest rates (nominal interest rate = real interest rate ♦ expected inflation rate) and, consequently, investment expenditure, aggregate demand, and actual inflation. They affect labour negotiations and, consequently, wages, production costs and actual inflation.
Economic policies work not only through their direct effects, but
also through their effects on expectations, including expectations of inflation.
The paragraph above is taken right out of my article on the "Macro-econometrics of Inflation Expectations," currently under editorial and referee review in a scholarly journal. The article sought to discern how consumers form their INFEXPs, as reported in the University of Michigan's Surveys of Consumers. It attempted to uncover elements that are believed to generate consumers' INFEXPs.
Other researchers have examined variants of technical economic variables plausibly related to inflation as the basis of consumers INFEXPs. To me, it seemed unlikely that ordinary consumers incorporate such technical information into their thought process when they respond to a telephone survey.
My theoretical framework assumes that consumers base their INFEXPs on their own direct personal experiences with the market prices of goods and services, and on the news they watch on television, hear on the radio and read in newspapers.
The economics based technical variables influence consumer INFEXPs only indirectly, through their effects on the market outcomes, which, in turn, are believed to influence their survey responses.
The empirical findings suggested that consumers form their INFEXPs on the basis of petroleum products prices, food prices, medical costs, the past inflation rate, and unfavourable news about the economy. Over 81% of the variance of consumer INFEXPs are accounted for by these five variables.
It is well known now that when the total money demand exceeds
the value of the goods and services available for sale, the economy is subject to inflationary pressures as prices increase.
In theory, rising prices themselves should self-correct inflationary pressure by reducing demand -- forcing prices down. Unfortunately, it doesn't always work that way; instead, inflation often reinforces itself, especially if incomes and prices increase in tandem.
If inflation persists, people learn to anticipate ongoing price increases and plan accordingly. If they expect the purchasing power money (PPM) to decline, there's greater tendency to spend for two reasons: today's money will be worth less tomorrow and prices are lower today than they will be tomorrow.
Why should inflation expectations matter so much? It so hap-
pens that when INFEXPs are managed well -- specifically, when they are anchored, the CB can best promote a sustainable economic growth path.
It is nearly impossible to maintain the stability of the exchange rate in a high-inflation environment. However, domestic currency appreciation reduces inflationary pressures from imports and allows the CB to continue its gradual interest rate increase.
To understand the inflation and inflation expectations generating processes one must make a crucial distinction between inflation and relative price increase.
Consumers often observe price increases in some daily essentials and become concerned that inflation has been set in motion -- a mistaken idea for sure. What they really experience is changes in relative prices -- price increases of
some goods in relation to other goods.
Inflation is a condition that afflicts all prices, not just the prices of particular goods or services. Changes in relative prices reflect changes in the supply and demand conditions of specific markets. The two aren't always so easily separable. Sometimes, we experience such a large and persistent relative price change that it temporarily ripples through the inflation data. The obvious example is oil prices.
Today, energy prices are increasing the costs of everything so adversely that it’s baffling virtually every business and household directly or indirectly. Purchasing the same amount of energy intensive goods and services requires people either to earn more, save less, or purchase fewer non-energy based items.
The government or the CB cannot offset these costs because they don't produce oil or increase the production of other essentials directly.
However, the CB is exclusively positioned to administer the nation s money supply. Therefore, one way to control inflation and INFEXs is to reduce the money
supply by raising the interest rates -- the benchmark rate that the CBs can control
To paraphrase a famous economist, Irving Fisher, the average price level doesn't rise because of the goods; it rises because of the money. Uncoupling the nexus between inflation and a relative price increase helps one understand the need for measures of "core" inflation (called the core CPI: consumer price index) or the core PCE (personal consumption expenditures).
Measures of core inflation attempt to shred away the most unstable relative price movements --like those of food and energy --which often, albeit temporarily, cause an aggregate price level fluctuation in a way that often fails to reflect a persistent change in the PPM.
Measures of core inflation are helpful metrics for the CB to gauge the PPM and take off-setting actions within its power.
Back in 1968, Nobel Laureate economist Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the expense of "just a little more"
inflation. He predicted that people would come to anticipate that extra inflation and then would change their behaviour in various ways. If policymakers still expected people to behave as they had in the past, they would attempt to do things that were no longer possible.
In effect, Friedman was warning policy makers not to treat inflation expectations as a static concept, but to appreciate the interdependence of inflation and inflation expectations.
This is my concluding piece in a series of four articles on money, inflation and monetary policy. What inspired me to write these articles is the alarming spectacle of the country's prevailing inflation environment that is taking a multitude of people everyday into the underclass and further impoverishing the already impoverished.
The Bangladesh Bank has a job to do: use anti-inflationary measures to break the persistence of inflationary expectations -• although they may cause some short term hardships, they will inevitably bring long-term relief.
Dr Abdullah A Dewan is Profossa of Economics at Eastern Michigan University, USA