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What is at is Optimal Rate of Inflation?

31 Mar 2017Economics Essays

The optimal Inflation rate can be negative, zero or slightly positive or can be any rate. The optimum rate depends on the economic perspective of the monetary Authorities and political imperatives. (Pally.T, 1998) That means the monetary policy can be based on the Friedman perspective, Neo Keynesian perspective and other economic models such as neo-classical perspectives as well it also depends on the experiences and unique market conditions in goods, labor market financial market and how they form expectation of inflation and how they react to inflation and the combination of perspectives used to determine the optimum rate of inflation. ( Akerlof G. A, Dickens.WT.Perry.L.G,2000)

Friedman perspective of optimum rate of inflation under perfect market conditions.

In a perfect economy any goods is priced at its marginal cost. (Sinclair.P & Norman. F 2003) If one defines money as currency its opportunity cost of holding that is its nominal interest rate such as treasury bill must be zero because as a fiat currency it will cost next to nothing. (Sinclair.P & Norman. F 2003). As well if any good or service is not provided at marginal cost will reallocate resources so that every one can gain and lead to waste. (Sinclair.P & Norman. F,2003). However the benefits of this asset depends on its real value. (Sinclair.P & Norman. F,2003).  Nominal rate of interest is composed of two elements.(Sinclair.P & Norman. F,2003).  They are the real interest rate, which is positive in the long-term and expected inflation. (Sinclair.P & Norman. F,2003).  If the nominal interest rate is zero and optimal means having a monetary framework where the prices are declining and inflation to be negative to keep the nominal interest rate negative or prices are expected to keep declining not the optimum rate of inflation positive but negative there fore under Friedman perspective discussed above the optimum rate of inflation must be negative. (Federal Reserve Bank of San Francisco 1997).   

The case for positive or zero optimum rate of inflation

In a neo-classical perspective the long-term Philip curve is vertical at non-accelerating Inflation rate of unemployment (NAIRU).(Hoover.K.D). That is in their perspective if government wants to reduce unemployment to reduce further than NAIRU it can achieve in the short –term however the market will tend gravitate towards NAIRU in the log-term and the rate of inflation will be more than before.(Hoover.K.D). If it controls inflation say my monetary policy at NAIRU the inflation rate will come down n the short-term however in the long-term the inflation will come back to the NAIRU level. .(Hoover.K.D). In their perspective optimum rate of inflation can be any rate given the structural market conditions in an economy and the fiscal and monetary policies adopted. They assume the market will always gravitate towards the NAIRU as there exist no price rigidities or stickiness in prices and wages as well all economic participants are rational in forming inflation expectation and react to inflation in a completely rational manner. .(Hoover.K.D).

However most monetary authorities even they have some faith in the NARU they have inflation targeting policies or to determine optimum inflation rate or to control inflation to this target rate my monetary and fiscal policy initiatives.(Palley.T 1998). However there are plausible arguments to have a slightly positive inflation rate by many economists. They prefer some neo-Keynesian perspectives and some perspectives of neo classical but have their own assumption regarding how economic agents form inflation expectation and particularly how they react to inflation.  The fundamental arguments are in a real market economy prices and nominal wages are sticky and minimum inflation has the effect of reducing the market power and help reduce prices. .(Sinclair.P & Norman. F,2003).   In practice economy has occasional recessions which may be a symptom of market failure and the nominal rate cannot be zero if they are to be cut to boost aggregate demand and there fore the optimum inflation rate cannot be negative.(Sinclair.P & Norman. F,2003). The effect of reducing the market power and help reduce prices. .(Sinclair.P & Norman. F,2003).   In practice economy has occasional recessions which may be a symptom of market failure and the nominal rate cannot be zero if they are to be cut to boost aggregate demand and there fore the optimum inflation rate cannot be negative. .(Sinclair.P & Norman. F,2003).  

The effect of reducing the market power and help reduce prices. .(Sinclair.P & Norman. F,2003).   In practice economy has occasional recessions which may be a symptom of market failure and the nominal rate cannot be zero if they are to be cut to boost aggregate demand and there fore the optimum inflation rate cannot be negative. .(Sinclair.P & Norman. F,2003).  The effect of reducing the market power and help reduce prices. (Sinclair.P & Norman. F,2003).   In practice economy has occasional recessions which may be a symptom of market failure and the nominal rate cannot be zero if they are to be cut to boost aggregate demand and there fore the optimum inflation rate cannot be negative. .(Sinclair.P & Norman. F,2003).   In addition a mild inflation, which is positive make less attractive to hold currency and may be a breaker of the damage caused by the retail-banking sector. .(Sinclair.P & Norman. F,2003).   Public finance consideration, which is the cause of market failure means that it is reasonable to tax money by mild inflation. .(Sinclair.P & Norman. F,2003).  

There is evidence to support that a mild inflation may lower-unemployment in the longer term. For example for the US Unemployment minimizing rate of annual inflation by Akerlof, Dickson and Perry to be some where between 1.5% and 4%..(Sinclair.P & Norman. F,2003).    As well Aherlof, Dickson and Perry argued that modest inflation have an effect of clearing the market and lower –unemployment. .(Sinclair.P & Norman. F,2003).   Wyplosz looks at the data for France, Germany, Switzerland and Netherlands and concludes that inflation is not completely independent of unemployment of the rate of inflation and tally with the view that with a little inflation helps to cut unemployment not temporarily. .(Sinclair.P & Norman. F,2003).   But it does not tell how high the inflation must be and these findings cannot be extrapolated for other countries and in time periods because of many reasons. .(Sinclair.P & Norman. F,2003).   The public finance argument is supported by Phelps and he argues that if public goods and transfers have to be financed by the wasteful distortionary taxes why should money holdings go un taxed and taxing money may alleviate such distortions and it may also tax informal-economy transactions which are normally conducted by cash. .(Sinclair.P & Norman. F,2003).    

Conclusion

The above analysis at least suggests that a slight optimum rate of inflation is plausible at least in the advanced industrialized countries. However the optimum rate of inflation can be different for different countries because of the different monetary Institutional structure and policy framework as well due to different market conditions and differences in the behavior of economic agents. How ever in a real market economy there are plausible arguments in favor of positive mild inflation rather than negative optimum inflation. This is at least empirically true on many advanced industrialized countries. 

The Friedman perspective of optimum negative inflation is not applicable at least in the advanced industrialized countries because of the plausible arguments discussed above and the empirical evidence supporting it. The determinants of the optimal inflation rate can also be in a policy level can also be influences in actual practice by political considerations and may change over time because of different economic models applied because of the usefulness and its theoretical and practical usefulness given the conditions and institutional changes and changes in the actual behavior of the economic agents. However given the complexity of economic workings and the occurrences of recessions and nominal rigidities and market imperfections in the labor market in particular empirically suggests that inflation targeting or the search for low-unemployment
Optimum inflation rate is plausible monetary policy at least in the more advanced Industrialized countries.

Bibliography

  • Akerlof. G.A  Dickens.W.T  Perry.G.L. (2000). Near-Rational Wage and Price setting and Optimal Rate of Inflation. Retrieved February 27, 2007, from http://eml.berkeley.edu//~akerlof/docs/inflatn-employm.pdf                                                        
  • Economist.Com, Falling Inflation is a World Wide Worry. (2001). Jubilee Research. 
  • Federal Reserve Bank of San Francisco. (1997). What is the Optimal Rate of Inflation, Economic Research & Data.
  • Hoover.K.D. Phiilips Curve, The concise Encyclopedia of Economics
  • Palley. T (1998). Zero is not the Optimum Rate of Inflation.
  • Sinclair.P & Norman. H (2003) The Optimal rate of Inflation: an academic perspective, Bank of England Quarterly Bulletin.

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