There is much that money cannot buy these days, for instance what it did not very long ago. Following the financial crisis abroad, the mavens have been taking a closer look at the phenomenon of spiralling prices, inflation and proactive monetary policy.
Note that one of the reasons stated for the crisis is that policymakers ignored runaway inflation of asset prices. A recent working paper at the IMF is on inflation targeting, but with the added assumption of ‘incomplete markets, credit constrained consumers and financial frictions.’
With more realistic assumptions, akin to those found in emerging markets, the paper finds that the optimal monetary policy rule is not to simply raise interest rates so as to rein in demand.
Rather, in the backdrop of a panoply of rigidities, what’s called for is the need to give due weightage to the ‘output gap’ prevailing vis-à-vis potential output, and to be much more nuanced and flexible in policy intervention.
The IMF paper opines that in complete markets, the price index that needs to be used for policy purposes is the consumer price index (CPI).
A recent RBI study too calls for a ‘representative CPI for the country as a whole.’ The paper notes that in the advanced economies, core inflation, which excludes food, energy and other volatile components from the headline CPI, is seen as the most appropriate measure to gauge price-rise.
The reason is that fluctuation in food and energy prices are taken as non-monetary supply shocks. Also, in the mature markets, food and energy consumption add up to a much lower share of income. In the rich world it would make policy sense to target inflation in the sticky price sector, or core inflation.
The paper’s thesis is that in incomplete, emerging markets, characterised by financial frictions and lack of credit availability, targeting core inflation by way of tighter monetary policy may not be optimal at all. For credit-constrained consumers are likely to be insensitive to fluctuations in interest rates.
Instead, as the demand of the latter depends only on real wages–inflation factored into nominal wages–there’s a direct link established between aggregate demand and real wages.
What’s posited is that such consumption behaviour ‘not only affects aggregate supply, but through its effect on real wages, also influences aggregate demand.’ The implication is that financial frictions ‘break the co-movement of inflation and output, as inflation and output may well move in opposite directions.
So stabilising inflation may no longer be sufficient to stabilise output, when markets are not complete. In such a policy environment, stabilising core inflation is no longer sufficient to stabilise output.
Besides, incomplete markets are characterised by credit-constrained consumers and a high share of expenditure on food in household expenditure.
The optimal monetary policy rule then is ‘flexible headline inflation targeting’, which involves taking into account headline inflation in policy design and duly factoring in credit offtake and unutilised capacity, read the output gap.
The paper uses newer modelling techniques and empirical crosscountry results to work out ‘the conditional welfare gains associated with each policy choice.’ Following a negative shock to the food economy, should the central bank indicate higher interest rates, the move lowers demand for unconstrained households, as it is optimal for them to postpone consumption.
However, the move can have no bearing on credit-constrained consumers. And to the extent that wage negotiations are determined by the price of wage goods, an increase in the relative price of food can increase wage income, and therefore boost consumption of credit-constrained households.
Further, the higher demand can more than compensate for the lower consumption demand of unconstrained consumers, says the paper.
In sharp contrast, when the central bank policy targets headline inflation, the price increases in the food sector tend to be lower, and ‘the rise in income and, therefore, the increase in consumption demand in that sector is not enough to compensate for the decline in demand of unconstrained consumers.’ Hence the need to use headline inflation for policy purposes and take into account the output gap, concludes the paper.
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