Inflation as a Solution?

February 16, 2010

by Andreas Hoffmann*  

The Wall Street Journal Online recently quoted an IMF paper (written by Oliver Blanchard), that a higher inflation may help to give leeway to monetary policy in times of crisis. What is this about?  

Blanchard argues that if inflation rates are targeted at 4 percent rather than 2 percent, this would not make much difference. Following Blanchard, the ‘2 percent target’ is chosen ad hoc. Further, two additional percentage points of inflation would not do any/much damage (by e.g. increasing the volatility of an economy). On the other hand, as inflation adds to nominal interest rates, these would increase with higher inflation. Thus, the room for interest rate cuts will be larger potentially to stimulate the economy in times of crisis.  

This sounds seductive. I have four comments:  

(1)   Blanchard is probably right when he argues that 2 or 4 percent would not matter much. But it is a target. Targets may be missed. The higher the target, the higher the probability of increased volatility. Or as Taylor asks in the article above: “If you say it’s 4%, why not 5% or 6%?”  

(2)   The investment function is not a function of the nominal rate, but of the real rate. Because I am sure that Blanchard did not forget about this, it brings me to –  

(3)   Cutting nominal rates (incl. 4 percent inflation) from 6 to 2 percent would result in negative real rates of 2 percent since prices would be stable for a while. Just as the current monetary policy this would allow for all kinds of investment projects with even negative returns. The inter-banking market would break down. Why would you lend someone money at risk when you profit from lending it at no risk. This should reinforce the deflationary tendencies of the crisis. Where is the improvement?   

(4)   Nominal interest rates did not decline because inflation declined over the last decade. Inflation was relatively stable. The leeway is gone because real interest rates have been cut strongly in times of crisis, but have been raised to a lesser extent in the following boom periods.  

Therefore, in my opinion, real rates have to be raised and lowered more nearly symmetrically in boom and bust periods. This would give leeway to monetary policy makers in times of crisis.

*Andreas Hoffmann is visiting the Department of Economics, New York University from the Institute for Economic Policy, University of Leipzig during the current academic year. He is a Bradley Fellow and a Fellow of the Friedrich Naumann Foundation. Some of his work can be found here.

8 Responses to “Inflation as a Solution?”


  1. A little bit of inflation is like being a little bit pregnant. Once the process has begun, it is ended at only great cost.

  2. Mario Rizzo Says:

    I wonder why Blanchard is fixated on just one aspect of inflation. I would imagine that if the target is raised, it is either expected or unexpected. If the former, then unemployment may spike until the target is reached as agents begin to incorporate the higher rate into their expectations perhaps more rapidly than it is achieved. If it is not expected there will be a temporary employment/income boost that will be hard to crush when expectations adjust.

    Also this leaves undetermined (as Andreas suggests) what the real rate policy is. Usually higher rates of inflation have been characterized by higher variance. If so, this makes decisionmaking and risk taking more difficult.

  3. Andreas Hoffmann Says:

    I guess what Blanchard has in mind is that this may help to protect against a scenario in which we have deflation, zero nominal interest rates, and thus positive real interest rates.

    But, does it? Won’t negative real interest rates in crisis periods lead to a deflationary spiral as banks may as well keep the money instead of taking the risk to lend it. These are the times when liquidity preference is usually high anyways.

    Further, Mario is right, higher volatility brings about less risk-taking and long-term investments and cannot be a great idea for long-term growth.

  4. Pietro M. Says:

    Models of the Zero Interest Rate Policy (Krugman, Eggertson & Woodford, Bernanke) that the REAL equilibrium (natural) interest rate can be negative, and persistently so (otherwise they couldn’t “explain” Japan) and that “a little bit of inflation” can create a buffer in case nominal interest rates hit the floor.

    It’s not to only to avoid a positive floor on real rates in a deflation, is to create a negative minimum floor.

    At the moment, due to mathematical details, I haven’t understood how the justify this hypothesis.

    It appears that the natural rate is defined as “the real rate at which the economy is in an optimal (flexible price) equilibrium”.

    AD shocks, due to nominal rigidities, may cause, for reasons I don’t understand, the equilibrium real rate to be negative.

    In the Eggertson/Woodford’s analysis of Japan, the real natural rate is hit by an exogenous shock and turns negative. Being a Markov process, it turns back after several periods, with a constant probability per period.

    I think it’s an ad hoc hypothesis to explain the Japanese crisis, a crisis that without a theory of structural problems (malinvestment) cannot be otherwise explained. But I miss the details of “Calvo price setting” and “Stiglitz-Dixit monopolistic competition”, without which I don’t understand the meaning of the equations. (Provided they have one)


  5. Two points, one factual and one theroetical.

    First, we have a labratory experiment in US history of rapid real economic growth and deflation. It was the Greenback Era and is well-examined in Friedman and Schwartz. What were nominal interest rates in that era?

    Second, much of the confusion over what would happen to interest rates in deflation comes from two errors: (1) the belief that interest if the price of money, rather than the price of time; and (2) the assumption of one interest rate, “the” interest rate.


  6. Blanchards proposal of a higher inflation target may even go beyond the futile attempt to restore the pitiful role of monetary policy as macroeconomic stabilization tool. Blanchard may intend to wean off the public from the idea that low inflation will persist. Policy makers meanwhile seem to see inflation as the easiest exit strategy from unorthodox monetary policies and excessive fiscal spending. I wonder what will be the consequence of rising inflation on government bond markets. Soon central banks may be forced to buy even more government bonds to steer against rising private unwillingness to finance ever rising public debt.


  7. Two pieces today are relevant to Gunther Schnabl’s points. Investor’s Business Daily reports that foreigners, including the Chinese, are cutting back their holdings of Treasury debt. That means more must be held domestically.

    No problem says Bob McTeer, former presidnet of the Dallas Fed. The Fed will happily monetize the Treasury’s debt.

    http://www.ncpa.org/sub/dpd/index.php?Article_ID=19001&utm_source=newsletter&utm_medium=email&utm_campaign=DPD

  8. Andreas Hoffmann Says:

    Thanks for the links. Just saw them, very interesting.


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