Some More on Targets and Inequality

Caution: wandering mind and thoughts in process of clarification.

After reading through Max’s useful feedback in the comment section to my post on the possible effects on inequality of raising the inflation target I was forced to rethink the whole issue somewhat. First of all let me start by saying that, in the bigger scheme of things, the effects of raising the target inflation rate by 2% on inequality are indeed likely to be small, so how much this even matters is a question of debate in and of itself, but I hate to leave loose ends untied. To recap a bit, clearly there is a big difference between expected inflation and unexpected inflation. A central bank increasing its target inflation rate would have the effect of moving the value at which inflation expectations are anchored.

Yet even if fully expected this would have real effects due to what is generally known as the Mundell-Tobin effect – essentially the fact that, due to cash always paying 0% nominal interests, portfolio choices would change. More precisely, people would want to move away from cash and into bonds (or whatever you want to call the financial product used in your model). This move into bonds would raise the prices of bonds while lowering their yields, and it is this switch in portfolio compositions that would also cause the real interest rate in the economy to fall compared to where it was before. It would also change the distribution of income and wealth through various channels. As an example, it might be possible that there are constant entry costs when it comes to entering the bond market. Clearly this would mean that poorer households would be less able to protect themselves from the higher inflation rate as participating in the bond market would involve decreasing average costs, thus increasing inequality. At the same time the literature on the topic generally assumes that poorer households are net-debtors in the economy, and lower real interest rates would mean lower real interest payments, reducing inequality. In short, it seems to be anyone’s guess which effects dominate. Inflation is also generally referred to as a regressive tax on cash holdings, which would again drive up inequality somewhat.

But enough of that: to the main point of the post: from a perspective regarding the most direct effects on inequality, is a higher inflation target or a higher NGDP target preferable? Clearly my first post implied that I consider the answer to be the latter. I am not so sure anymore. As Max correctly pointed out, the change in inflation rate (a one-off effect) affects inequality, but within the moderate levels of inflation we’re talking about, there seems to be no reason to assume that inequality would be meaningfully affected beyond this initial movement. The big difference now between a higher inflation target and an NGDP growth or growing level target would be the degree to which inflation changes over time. Ideally, in the first case it would not change at all, while in the second case inflation would fluctuate as RGDP fluctuates.

Essentially it would seem RGDP, for different reasons including exogenous shocks, would fluctuate under both targets. The main advantage of an NDGP target would be to reduce this fluctuations since, much like the Taylor rule, it includes both output and inflation, while a strict inflation target (like the one of the ECB) does not. Clearly, however, the variance of inflation would, if the central bank does its job, be bigger under an NGDP target. That’s pretty much the feature of it. But, and in line with the thoughts outlined above, this would also mean that constant (essentially central bank-induced changes) in the inflation rate would, even if fully expected, also lead to constant (therefore also essentially central bank-induced) changes in real interest rates. Again, of course this is part of the idea – if RGDP falls, inflation would rise to meet the NGDP target, and real interest rates would fall (not only all other things equal but despite all other things adjusting), which would boost the economy causing RGDP to rise again – the whole point of the exercise.

Now, the general assumption is that variance in RGDP is bad for welfare – we would much rather have a constant real growth rate of, say, 2% per year than growth that is all over the place yet, over a certain period of time, averages 2% as well. Yet what does variance in RGDP do to inequality? I honestly would not know. In general, people with lower qualifications (i.e. on the lower end of the income spectrum) would get fired first in a downturn, but then again they also get hired first in an upturn. Is this process symmetric? That would seem to depend on the costs of hiring and firing people. If they are similar, the process would probably be symmetric, and the impact on inequality unimportant on average. But it would not seem farfetched to argue that, due to e.g. transaction costs and other market imperfections, variance in Inflation hurts the poor more than the rich. Again, if the technology for “inflation protection” (i.e. switching from cash to bonds) has decreasing average costs, as is likely, every switch would be more costly for poorer households than for richer ones. In short, the costs of protecting against inflation, which arise particularly when inflation changes, seem to be higher the poorer you are. So on these isolated grounds, a higher inflation target may be more desirable from a strict inequality standpoint.

Again, probably fairly trivial and not even I’m sure this really matters, but just sayin’.

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6 thoughts on “Some More on Targets and Inequality

  1. Flo, I think it would really help to have a formal framework to discuss all this. Cause I’m already getting confused by all the different channels through which various monetary policy regimes could possibly affect inequality. I’m not talking full-on DSGE, just a small tractable model which gets to the essentials. Just sayin’.

  2. You are as right as one can possibly be, but I have unfortunately never actually modeled something myself (you got to start somewhere though, I guess) and am currently a bit busy trying to pack my master’s thesis ideas into something resembling a formal model – I’ll see if I come up with something for this nonetheless. I love the idea of whipping something into a small and tractable model, and mathematically most of it would probably be fairly easy, but so far I have never done so. Thanks for the hint though – it is indeed something I sorely lack and am eager to fix. If some basic framework (i.e. something that’s already been written) comes to mind that I might use to build on, I’d love to take a crack at it. Atm not quite sure how to start from scratch.

    PS: I have never understood how I was allowed to get this far without ever being asked in some class to do some modeling of my own, even on the most basic level, but here I am, and I’m far from the only one…

    • One thing: i am not sure you are quite correct when you say rgdp is generally more volatile under inflation targeting than under ngdp targeting.
      This is certainly right when we are talking about supply shocks. If the AS curve shifts to the left, inflation targeting forces you to contract AD. But if shocks are coming from the demand side i think there is no difference between the two regimes. Both require cranking the AD curve back up to its original position.

      PS: Oh yes. There should definitely be more model building in the econ curriculum.

      • Even if we use your static framework, the fact that inflation targeting prescribes the “wrong medicine” for supply shocks already makes it so NGDP targeting, on average, reduces RGDP variance. But dynamically speaking both expectations and the extent of the monetary reaction to a shock play a role. Not in all shocks, but in many, and enough that it matters. To name the recent crisis as an example, a stronger monetary policy from the get-go (leaving aside the problems of the ZLB for now) would almost certainly have reduced the amount by which output was allowed to drop below potential. There is strong reason to assume that, even in practice, an NGDP target would lead to a stronger reaction than a mere inflation target. In a static AS-AD model essentially the amount by which AD would shift downwards would be smaller, both due to expectations of stronger stimulus but also due to very real stronger stimulus.

  3. Ok, let’s do this. Suppose we start from long run equilibrium, ie intersection of AD and LRAS, where inflation is 2% and real growth 3%. A demand shock hits, shifting AD down. If monetary policy would do niente, there would be a new long run equilibrium at, say, 1% inflation and 3% real growth. Now, if the central bank targets 2% inflation it has to bring AD back to its original position. They would have to do exactly the same if they would target 5% ngdp growth. I don’t see any difference. What am I missing?

  4. In the static framework you are using with the assumption of an exogenous shock you are not missing anything. What is left out is the path AD takes to go from its initial position to its new position, and the path it takes back (as well as the speed with which it takes this path back). The analysis would seem to be correct for the bursting of the dotcom bubble, where the demand shock arrives, and we’re basically done. A credit-driven bubble, like the recent housing market bubble, is more prone to entering a stronger self-inforcing downward spiral (beyond the obvious Keynesian multipliers), the continuation of which depends very much on both expectations as well as degree of monetary policy activism.

    Put differently: Would you say that the output gap in the recent crisis would have been bigger (at its maximum as well as in general) if central banks did not exist at all? If yes, and therefore the presence of a central bank changes the outcome, the degree to how much this central bank does must change it as well (not for all slumps, but for this specific one). If no, then I guess I’ll have to see if I do find a model that describes this more clearly than I do, but dynamic models are somewhat nasty things.

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