Select a country that has gone through a period of significant disinflation. Collect and plot data on its inflation and employment during that period and discuss the costs of disinflation. Using the IS-PC-MR model, discuss how the concept of anchored expectations can be used to reduce the costs associated with disinflation. (2000 words)
A period of significantly high inflation arises as the primary outcome of a situation where there is a conflict of interest between employers and employees in the labour market. This reflects a negatice deviation from the natural rate of unemployment such that unemployment is below equilibrium. As a consequence, employees are expecting a higher real wage, when in reality the real wage rate remains unchanged as firms seek to maximise their profits and set wages according to this objective. Episodes of high inflation often precede periods disinflation where a period of output below the equilibrium level accompanied by high unemployment is required in order to slow the inflation rate and bring it back to the targeted one (Carlin and Soskice, 2015) Disinflation differs from deflation which occurs when prices are actually falling, as it is reflective of an inflation rate (general price level) that is rising but at a slower rate. In some situations, disinflation can in fact lead to a period of deflation if the inflation rate slows so dramatically that it falls to a rate of 0, thus the economy is at risk of falling into a deflationary trap.
In the early 1990s, Japan experienced an on-going period of disingaltion in its economy. This disinflation continued for the eight years following, and from the mid 1990s Japans’ inflation rate declined into negative territory, and Japan found itself trapped in a deflationary spiral. . (http://www.telegraph.co.uk/comment/personal-view/3563614/What-Japan-can-teach-us-about-deflation.html) This period of disinflation was due to the initial shock of the bursting of a major asset bubble severely impacting aggregate demand levels. (https://www.socialeurope.eu/2014/09/japanese-deflation/) The bursting of the asset bubble was helped along by the Bank of Japans’ monetary policy, which was to rise inter-bank lending rates in an attempt to deflate speculation and control inflation.
“During the 1960s and 1970s, increasing exports played a key role in Japanese economic expansion, and throughout the 1970s, Japan had the world’s third largest gross national product (GNP) – just behind the United States and the Soviet Union” Looking at figure one which shows Japans inflation rate changes between 1970 and 2000, it is evident that Japans inflation rate peaked in 1974 at an average of 23%. This period of strong growth ended rather suddenly at the start of the 1990s “due to actions by the Bank of Japan (BoJ) and the Stock Markets crashed and unemployment rose”. Figure two shows the rise in the levels of unemployment in comparison to the changes in the interest rate in 1991 through to 2000 following the bursting of Japans asset bubble.
The extent of the costs of disinflation depend largely on the economic model used, for instance the Classical model suggest low costs whilst the Keynesian model suggest high costs. In the short run, a rising level of unemployment is a significant cost of reduced economic growth arising from a drastic reduction in money growth. Various economic models have different views on the longevity of the impact this will have on an economy. The Classical model posits that in the medium run the eocnomiy will return to its natural rate of unemployment fairly quickly, whereas under the Keynesian model, the slow adjustment of wages and prices will prolong a period of higher unemployment. However, both models agree that the speed at which the adjustment takes place depends on the believe about the credibility of the banks’ commitment to reduce the inflation rate (Croushore, D. 1992)
As aforementioned, a negative output gap is required to bring about a slower rate of inflation; this concept is captured by sacrifice ratio. This represents the percentage point rise in unemployment experienced for a one percentage point reduction in inflation (Carlin and Soskice, 2015) This assumes that there is a one-for-one relationship between changes in employment and output, when in reality this is not the case. “The empirical relationship between changes in the growth rate relative to its trends and changes in the employment rate is called Okun’s Law” (Carlin and Soskice, 2015) According to this law, a 1% change in output growth above or below its trend is often associated with a fall or rise in the unemployment rate of less than one percentage points.
The Phillips Curve (PC) reflects the relationship between unemployment and the inflation rate as the economy moves from the medium run equilibrium and express this in terms of the disinflationary output gap, . Employers (wage setters) change the wages they pay their employees to compensate for the price prior to the current period – This is known as adaptive inflation expectations. In terms of Japan, there is a negative relationship between unemployment and inflation. “In setting out the 3-equation model, we make two ad hoc but empirically based assumptions: the firSt relates to the persistence of inflation and the second to the time lags in the economy” and “in terms of adjustment lags, we assume that it takes one year for the monetary policy to affect output and a year for a change in output to affect inflation” (Carlin and Soskice, 2005)
The Central bank uses monetary policy to maintain a stable economy alongside keeping the inflation rate close to the target rate. These objectives are put into action using what is known as the ‘Monetary Rule’ in which “the central bank adjusts its interest rate in line with inflation with the goal of meeting an inflation target”. As the CB cannot directly alter the inflation rate, it utilises alterations in the interest rate to maintain the targeted inflation rate. The Monetary Rule (MR) represents the banks best response output-inflation combination, once this has been determined the CB will then set the required interest rate using the IS curve. The MR is derived using the CBs preferences to determine the indifference curves and the CBs constraint (Phillips Curve). The best response monetary rule, where the bank can minimise its loss function and remove the output gap, lies at the point of tangency between the two curves. The CBs preferences can be represented by the following loss function,
The higher the central banks’ loss function the worse off they are due to differences in , which represents the relative degree of inflation aversion, thus when is higher the output sacrifice will also be greater. It is evident from the data that the preferences of the Bank of Japan were directed toward a more inflation averse strategy of disinflation. There are two strategies for disinflation: “cold turkey’ and ‘gradualism’. It is a reasonable assumption that Japan had opted for a ‘cold turkey’ approach to disinflation. With such an approach, Japan achieved a faster fall in inflation but experienced sharper rises in its unemployment level. This differs from the more gradualist approach which would have allowed for a slower process of disinflation and a lesser rise in unemployment.
Once the best response output gap has been derived, the CB sets the interest rate using the real interest rate on the IS curve.
The three equation model helps to explain a central banks’ response to an inflation shock (exogenous shock that affects the Phillips curve). The graph below depicts the central banks response to a positive inflation shock.
In the period prior to any inflation shock (period 0), it is assumed that the economy starts at a point of equilibrium where inflation is at the target rate of pieT, and the interest rate is set at the stabilising rate rs – the central bank’s bliss point. A positive inflation shock shifts the PC curve from point A on to point B on the curve because of inflation expectations. At this point, the inflation rate has increased however, output remains the same. As the MR rule states, loss is minimised where MR intercepts the PC curve, which is at point C in the figure above. Therefore, the central bank raises the interest rate to r0 for one period, however it expects the IS curve to shift back to the original in the next period. In period 1, the interest rate has had time to dampen investment levels, thereby reducing real output. The economy therefore shifts to point C on the MR curve where output is at y1 and inflation is at pie1. Given that the observed inflation rate is lower than the previous inflation rate, the central bank adjusts its expectation and forecasts a shift right of the PC curve to and the interest is reduced to r1. In period two, the loss minimising point for this PC curve is at point D due to the increase in demand from the lower interest rate. This boosts output to y2 and actual inflation falls to pie2. The PC curve continues to shift downward until the expected rate equals the actual inflation rate at the medium run equilibrium.
So far the assumption has been that wage-setters have adaptive expectations