Suppose that the price of an imported consumer good rises significantly. This could be due to a decrease in the global supply or else an increase in foreign demand. Further, suppose there is no import competing industry for this particular good.
Suppose demand for the imported good is unit elastic. Quantity demanded falls in proportion to the increase in price, so that total spending on the product remains unchanged. Foreign exchange markets continue to clear. The total amount spent on imports is unchanged as is the total amount earned from exports. Spending on domestic product is unchanged as well. Spending on domestic product generates an equal nominal income.
Real income has fallen. The price level, including the imported good, is now higher. And so, deflated by that index, real income is lower. Less of the imported good is enjoyed.
With nominal GDP targeting, this is all that happens. Spending on domestic product and nominal income were not impacted.
On the other hand, if the consumer price level is targeted, then the increase in the price of the imported good pushes the price level above target. This would trigger a monetary contraction. For the most part, the result would be reduced prices of domestically produced goods and services, with their prices falling enough to offset the inflation in the price of the imported consumer good. Of course, since falling demand for any particular good often signals the need to contract production, it is likely that output and employment would fall as well. Hopefully, in the long run, wages and other nominal incomes would shift to a lower growth path, leading to lower unit costs, and so a recovery of production and lower prices of domestic goods.
To the degree that the monetary contraction triggers higher interest rates and a net capital inflow, the exchange rate will rise. This could directly dampen the increase in the price of the imported consumer good, lower the prices of other imported goods, and reduce the foreign demand for exported goods. One the prices of exported goods and imported goods fall, the appreciation of the currency will be justified by purchasing power parity.
With inflation targeting, if the increase in the price of the imported consumer good comes as a surprise, (like the realization of a random variable,) then it is ignored. Bygones are bygones. There has been a temporary spike in inflation. Unfortunately, if the price of the consumer good is foreseen, and part of an ongoing process in real time, then inflation targeting would require a monetary contraction as above.
Of course, with "flexible" inflation targeting, the central bank can allow inflation when it thinks it best. But then, that isn't much of a rule.
Could it be that a large run up in oil prices, partly due to supply problems in the Middle East and Africa, but also due to growing gasoline demand from India and China, combined with "flexible inflation targeting," has led to an economic contraction that aims to force down other prices, including wages and other nominal incomes, enough to keep inflation on target?
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Yes, fighting global commodities inflation with domestic monetary policy is a fool's game.
ReplyDeleteYou tank your own economy, and have fleeting effect on global commodities (unless you cause of global economic slowdown).
This was the lesson of 2008.
It is also the reason that perversely fixating on inflation is a very, very poor way to run a monetary policy.
Keep your eye on the ball: Real growth. That target is best obtained through nominal GDP targeting.
I'll say it again: I would rather live with 5 percent inflation and 5 percent real growth and than 1 and 1.
Inflation is not important. Real growth is important.
What happens if the imported good is not unit elastic and people spend more of their income on it.
ReplyDeleteThis would put downward pressure on other prices but if they were now flexible then sales would fall and we would have a recession.
It seems that an increase in the money supply would be beneficial but neither NGDP targeting or inflation targeting would lead to this result. An increase in the money supply might raise inflation expectations and lead to problems down the road.
What would MMist recommend in this situation ?
re last comment "not flexible" not "now flexible"
ReplyDeleteIf it is not unit elastic, then it depends on whether it is elastic or inelastic.
ReplyDeleteThe "downward pressure on other prices," is the inelastic scenario. Quantity demanded falls less than price rises, and total spending rises on the imported good.
If total spending is fixed (total domestic purchases is the measure) then there must be less spending on other goods, presumably domestic goods. That seems plausible enough, though if nominal spending on domestic product is fixed, that isn't what happens.
Anyway, one avenue of ajustment that you are ignoring is the change in the exchange rate. The increased spending on the higher priced imported goods tends to reduce the exchange rate. This changes relative prices in a way so that increaced foreign demand for exports and reduced domestic demand for other imports reduce any effect on the demand for domestic output. In other words, demand for domestic output isn't the same thing as domestic purchases of output.
If fixed exchange rates are assumed, so that additional spending on the higher priced consumer good results in a monetary contraction to prevent a decrease in the exchane rate. This forces down nominal incomes (and costs) so that external balance is obtained.
Anyway, with nominal GDP targeting, the demand for domestic output continues to grow on target one way or another. In this simple sceanario, keeping nominal GDP on target requires a lower exchange rate, while keeping domestic purchases on target would allow for a higher exchange rate, lower import prices, but reduced nominal income and costs.
With capital flows (say an inflow to help fund a larger trade deficit,) then the natural interest rate is slightly lower, which leads to an expansion of domestic interest sensitive industries.
Anyway, nominal GDP targeting 'corrects' the problem mostly through higher import prices.
Thanks for the detailed answer. I guess the key is that that higher import prices for an inelastic good mean that the economy will have to give up more of it own products in exchange for that good and consume less as a result. NGDP targeting cannot address that reality. It can however, by sticking to the target, address any side effects in terms of the demand to hold money that might arise as the economy adjust to the new import prices.
ReplyDeleteIn fact, Consumer Price Index is an incorrect representation of reality as stated in Ed Butowsky video "Inflation Nation".
ReplyDeleteFrankly speaking it’s pretty hard to suppose these stuff, as it can have completely different impact on things, so that’s why we need to be careful in how we work out. I trade with OctaFX broker where and they help me a lot especially with rebate program where I am able to earn 15 dollars profits per lot size which includes the losing trade as well, so that’s why I love it and always believe it’s great to be working with them.
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