Guideposts for Anti-Inflationary Monetary Policy

Having lost the nominal anchor of fixed exchange rates, and with inflation at postwar highs, central banks in many industrial countries starting in the mid-1970s adopted monetary targets to guide the conduct of monetary policy. Soon, however, problems with this framework began to surface. In some countries, the abandonment of quantitative restrictions on bank credit led to reintermediation into the banking system and upward shifts in some targeted monetary aggregates. In other cases, innovations in the financial services industry, in part sparked by high rates of inflation, led to downward shifts in the demand for money, so that a given rate of monetary growth would be associated with more expansionary pressure than might have been expected judging from the historical relationship between money and income growth. This played an important role in the inflationary process of the 1970s in a number of countries, as central banks at times found themselves tightening policy but not catching up with the increasing rate of inflation. Such instability of money demand, especially in the context of supply shocks and declines in potential output growth, complicated the task of monetary authorities. As a result, during the 1980s most central banks—with some notable exceptions—either abandoned or downplayed the role of monetary targets.

A related factor that complicated the task of monetary policy in the 1980s in a number of industrial countries and contributed to the third of the inflation peaks referred to earlier was the rapid expansion of credit in the wake of financial market deregulation and liberalization.⁷⁷ Much of this credit growth expanded the demand for assets such as corporate stocks and real estate, leading to a run-up in asset prices. This inflation in asset markets was for the most part not directly reflected in conventional measures of inflation relating to the flows of production and consumption of goods and services. But it contributed to the expansion of aggregate demand and subsequent inflationary pressures in goods and factor markets. The excessive growth of credit and the associated rise in the private sector’s financial leverage meant that by the second half of the 1980s, households and businesses were quite vulnerable to the effects of higher interest rates. Hence, as monetary policies were tightened in the late 1980s, the resulting balance sheet adjustments led to asset-price deflation in a number of countries, most notably Japan and the United Kingdom, but also in Australia, Finland, France, New Zealand, Norway, Sweden, and the United States. One consequence of this asset-price deflation was an increase in nonperforming loans, which was reflected in financial sector distress in the United States, Japan, France, and the Nordic countries. Another was prolonged economic slowdowns in the countries most affected.

The lesson that emerges from the experience with monetary targeting is that monetary aggregates cannot be relied upon to provide intermediate targets sufficient in themselves to guide monetary policy. So what should be the guideposts for monetary policy? For a country that pegs its exchange rate to a major currency, the monetary policy framework is greatly simplified: all of the information necessary to guide monetary policy is summarized in one variable.⁷⁸ For countries that forgo a pegged exchange rate, and in particular for the three major reserve currency countries, whose currencies are freely floating, the monetary policy framework is more complex and necessarily more pragmatic. The significance of any particular indicator can vary with circumstances, including the conduct of policy and the development of financial markets. This has become particularly apparent from the breakdown of relationships between monetary aggregates and prices and real activity in the early 1980s, as well as from the experience of the latter half of the 1980s, when the formulation of monetary policy paid inadequate attention to asset-price developments.

In practice, monetary authorities have therefore found it useful to monitor a range of indicators, including monetary and credit aggregates, that have potential predictive content for the ultimate goal of policy. A variety of indicators is needed because no single indicator can adequately summarize the stance of monetary policy and because each indicator is subject to influences other than monetary policy; the chances of correctly identifying the nature of economic disturbances are therefore greater by observing several indicators. A disadvantage of this approach is that the monetary authorities do not reap the potential credibility benefits that the commitment to a single variable can bestow by serving as a focal point for expectations. It is in part to overcome this drawback that a number of central banks in recent years have adopted formal inflation targets. Not all countries, however, have the technical means to carry out and to develop the necessary credibility for such a forward-looking policy framework. The use of inflation targets is discussed further in Box 8.

Special Features of Inflation in Developing and Transition Countries

The inflationary process in many developing and transition countries differs from that in the industrial countries because of the larger role of fiscal deficits, which in turn partly reflects the limited development of domestic financial markets. Additional, albeit temporary, complications in many transition countries have been the role of price liberalization and the existence of monetary overhangs.

Fiscal pressures have contributed greatly to inflationary surges and to chronic inflation, as many countries have monetized large budgetary deficits. In many developing countries, fiscal pressures intensified in the 1980s because of the debt crisis. Unlike in the industrial countries, inflation rates in the developing countries as a group did not fall back to trend levels following the successive supply shocks, but instead drifted upward throughout the 1980s and early 1990s (Chart 38). Of course, these average (in Chart 38, median) inflation rates combine together countries with quite varied inflationary experiences, ranging from the extreme inflations in countries such as Argentina, Bolivia, and Brazil to the more moderate or even low inflation rates in many Asian countries such as Thailand, Korea, Malaysia, and Singapore. In recent years, widespread and substantial progress has been made in lowering inflation through determined stabilization efforts. In many countries, however, inflation rates remain in the double digits and continue to impose substantial social costs. Moreover, countries with inflation rates in the 20–30 percent range, or higher, may face the risk that inflation will ratchet up to even more damaging levels (see below).

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Developing Countries: Inflation Across Regions

(Median, percent change)

Inflation has fallen recently in most regions.

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Part of the reason for the persistence of inflation at double-digit rates is governments’ reliance on seigniorage for a substantial portion of their revenue—nearly 25 percent in high-inflation countries (Table 35). The underdeveloped nature of tax collection systems and institutions in many developing countries provides a powerful incentive for money creation, since the inflation tax can be levied without the need for a revenue collection infrastructure. In such countries, fundamental fiscal reforms are often necessary to prevent disinflation from leading to a deterioration in budgetary performance. On the other hand, at extremely high rates of money growth—where seigniorage equals around 10 percent of GDP⁷⁹—inflation can lead to demonetization of the economy, so that transactions are made either by barter or with a foreign currency such as the U.S. dollar. In this case, seigniorage revenue can fall in real terms, as the tax base (i.e., the demand for money) shrinks by more than the increase in the tax rate (i.e., the rate of inflation). Moreover, high inflation can erode the real value of tax revenues.⁸⁰

Table 35.

Importance of Seigniorage in Importance of Seigniorage in Developing Countries

(Change in monetary base as a fraction of GDP and government revenue)

Note: The figures cover 71 countries.

Table 35.

Importance of Seigniorage in Importance of Seigniorage in Developing Countries

(Change in monetary base as a fraction of GDP and government revenue)

	Average Inflation Rate, 1960–94
	Below 5 percent	5–15 percent	Above 15 percent
GDP	1.5	1.9	4.4
Government revenue	6.4	10.7	24.0

Note: The figures cover 71 countries.

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Table 35.

Importance of Seigniorage in Importance of Seigniorage in Developing Countries

(Change in monetary base as a fraction of GDP and government revenue)

	Average Inflation Rate, 1960–94
	Below 5 percent	5–15 percent	Above 15 percent
GDP	1.5	1.9	4.4
Government revenue	6.4	10.7	24.0

Note: The figures cover 71 countries.

Box 8.

Inflation Targets

In recent years, there has been a growing trend toward the adoption of inflation targets as the primary focus for the conduct of monetary policy.¹ Countries that have adopted official inflation targets in the 1990s include (in chronological order): New Zealand, Canada, the United Kingdom, Sweden, Finland, Australia, and Spain (see table on page 110 for details). By focusing attention on the ultimate goal of monetary policy—that is, reasonable price stability, which is generally understood to mean inflation at rates low enough not to affect economic decisions—inflation targets may be argued to provide a more transparent framework for policy than alternative frameworks based on monetary targets or pegged exchange rates. Indeed, inflation targets were typically adopted after unsuccessful experiences with either monetary aggregates targeting or pegged exchange rates, or both. Inflation targeting may not be the most appropriate monetary policy framework for all countries, however. It has been most useful in cases where policymakers have needed to establish a credible commitment to low inflation policies. A number of countries that have been relatively successful at achieving and maintaining low inflation, including the United States, Japan, and Germany, have continued to eschew formal inflation targets.

Explicit inflation targets play two main roles in efforts to reduce and control inflation: first, by communicating to the public the objective that monetary policy seeks to accomplish, they serve as a coordination device in wage-and price-setting processes and in forming the public’s inflation expectations; and second, they provide a transparent guide to the conduct of monetary policy, whose commitment and credibility can then be assessed on the basis of whether policy actions are taken to ensure that the targets are achieved. Accordingly, in those countries that have adopted them, inflation targets have become a key nominal anchor. Usually, inflation targets have not been supplemented by explicit intermediate targets for other nominal variables, such as monetary aggregates, though in principle it would not be inconsistent to do so.²

The shift toward inflation targets finds support from various developments in theoretical and empirical research. One of these is the emphasis on reasonable price stability as the primary goal of monetary policy. This follows mainly from research indicating that in the long run monetary policy affects only on nominal variables, such as the price level, and has no marked impact on real economic activity. A second development is the insight that any attempt to exploit the existence of short-run nominal rigidities to lower the rate of unemployment tends to impart an inflationary bias to monetary policy. A credible commitment to an inflation target can attenuate the extent of such inflationary bias, but possibly at the expense of raising the variability of output.³ A third development is research indicating that transparency and openness of the operating framework of monetary policy can bring important credibility gains, and that institutional arrangements such as greater independence of the central bank can be helpful in this regard. Hence, it is perhaps not surprising that in many countries the adoption of official inflation targets has been accompanied by moves toward central bank independence and accountability. In addition to developments in economic research, practical considerations, such as failures with monetary targeting and pegged exchange rates, have also played an important role in the adoption of inflation targets.

Once an explicit inflation target is adopted, the authorities need to specify the price index to be used in calculating the inflation rate, the target inflation rate or range, the horizon over which the target applies, and the situations under which the target may be modified or even disregarded. In practice, countries have set targets for the rate of inflation rather than the price level, which implies that overshooting the inflation rate target need not be followed by undershooting, as would be the case if the objective were absolute stability of the price level. As discussed in the main body of the chapter, a variety of theoretical and statistical arguments have been advanced in favor of targeting a low, but non-zero, inflation rate. Most inflation targets have been specified as inflation bands with widths of up to 3 percentage points. While a single target rate might most effectively serve as a focal point for inflation expectations, a relatively narrow band may be more credible in view of the authorities’ necessarily imperfect control over inflation. As to the appropriate price index, some countries target an inflation index that excludes particularly volatile items such as food and energy prices, indirect taxes and subsidies, and interest cost components; others directly target the broadly defined consumer price index.

There are important differences across countries in the legal and institutional support for inflation targets. In New Zealand, the targets were established as part of a thorough institutional reform, including a legislated goal of price stability and an independent and accountable central bank. In some other cases, targets have been established by the central bank without an explicit commitment by the government to achieve them. In addition, accountability by the monetary authorities for their actions can vary considerably. For example, in the United Kingdom, although the Bank of England was given greater operational independence in determining the timing of monetary policy actions following the introduction of inflation targets in 1992, the Chancellor of the Exchequer (who is accountable to Parliament) retains control of monetary policy; but many other central banks are directly accountable to the legislature.

Operationally, since monetary policy affects economic activity and inflation with long lags, and since knowledge of the monetary transmission mechanism is imperfect, policy must be forward looking and policymakers rely on multiple indicators to evaluate the economy’s inflation outlook. These indicators include monetary aggregates, the yield curve, movements in asset prices, market- or survey-based expectations of inflation, forecasts of the output gap, indicators of the fiscal stance, and exchange rate forecasts. Based on their evaluation of the inflation outlook, the authorities can choose a time path for the monetary policy instruments that result in a conditional probability distribution of future inflation that is consistent with achieving the inflation target. In fact, instead of setting policy instruments on the basis of point estimates of future inflation, a more fruitful procedure has been to assess the risks and uncertainties associated with the inflation outlook and to set policy instruments according to probable inflation outcomes.

Since the decision-making process of monetary policy involves assessing current and future inflationary trends and comparing these trends with the announced inflation target, the process leaves room for discretion, the use of which in turn will affect the credibility of policy. These considerations point to the importance of the transparency and openness of the conduct of policy in relation to the operating framework. Thus, some aspects of the monetary policy process in the United Kingdom since 1992, such as the Bank of England’s Inflation Report with its carefully argued inflation forecast, and the publication of the minutes of meetings between the Governor and the Chancellor, have increased the transparency of the conduct of policy and increased the accountability of the treasury and the bank to the public.

In most countries, performance with inflation targets thus far has been satisfactory in some important respects. Despite the less-than-full credibility of the targets, which may be inferred from ex ante discrepancies between measures of the public’s inflation expectations and the targets, inflation objectives have in most cases been achieved or surpassed. While this performance may seem impressive, a more complete judgment awaits the passage of at least a full business cycle. In most countries, the targets were introduced in periods of considerable economic slack, making it difficult to judge their performance since countries without explicit targets have also experienced low inflation in recent years. The advent of greater inflationary pressures in the future may show more decisively the effectiveness of inflation targeting relative to other monetary policy frameworks. These pressures—if and when they arise—may give rise to divisions about the goals of monetary policy, which in turn may constitute a substantial test of the credibility and functioning of inflation targets. Last, it should be emphasized that formal inflation targets are only one aspect of macroeconomic policy. As such they are likely to funtion best when fiscal policy and wage behavior are compatible with the inflation targets, and when there are supportive institutional arrangements concerning the status and policies of the central bank.

Inflation Targets in Selected Countries

Inflation Targets in Selected Countries

Country	Date of Adoption	Current Target Rate and Horizon	Price Index	Other Details
New Zealand	March 1990	0–2% through the 5-year tenure of the Governor of the Reserve Bank	Consumer price index (CPI) excluding interest cost components, indirect taxes and subsidies, government charges, and significant price effects from changes in the terms of trade.	Target set in Policy Target Agreement (PTA) between the Minister of Finance and the Governor of the Reserve. Bank of New Zealand
Canada	February 1991	1–3% through 1998	CPI	The measure of underlying inflation used by the Bank of Canada for operational purposes is the CPI excluding food, energy, and the effect of indirect tax changes. Target set by the Minister of Finance and the Governor of the Bank of Canada.
United Kingdom	October 1992	Lower half of the 1–4% range by spring 1997;2½%, or less thereafter.	Retail price index excluding mortgage interest payments (RP1X).	Target set by the Chancellor of the Exchequer.
Sweden	January 1993	2% (with a tolerance band of ±1%) in 1996 and beyond	CPI	Target set by the Bank of Sweden
Finland	February 1993	About 2% in 1996 and beyond	CPI excluding indirect taxes, government subsidies, house prices, and mortgage interest payments.	The target rate has no explicit band. Target set by the Bank of Finland.
Australia	1993	Underlying inflation of 2–3% on average, over the cycle	CPI excluding the impact of interest rates on mortgage and other interest payments, indirect tax changes, and certain other volatile price items.	Target set byt he Reserve Bank of Australia, and endorsed by the government, in the statement on the Conduct of Monetary Policy by the Treasurer and the Governor of the Reserve Bank
Spain	Summer 1994	Less than 3% by late 1997	CPI	Target set by the Bank of Spain.

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Inflation Targets in Selected Countries

Country	Date of Adoption	Current Target Rate and Horizon	Price Index	Other Details
New Zealand	March 1990	0–2% through the 5-year tenure of the Governor of the Reserve Bank	Consumer price index (CPI) excluding interest cost components, indirect taxes and subsidies, government charges, and significant price effects from changes in the terms of trade.	Target set in Policy Target Agreement (PTA) between the Minister of Finance and the Governor of the Reserve. Bank of New Zealand
Canada	February 1991	1–3% through 1998	CPI	The measure of underlying inflation used by the Bank of Canada for operational purposes is the CPI excluding food, energy, and the effect of indirect tax changes. Target set by the Minister of Finance and the Governor of the Bank of Canada.
United Kingdom	October 1992	Lower half of the 1–4% range by spring 1997;2½%, or less thereafter.	Retail price index excluding mortgage interest payments (RP1X).	Target set by the Chancellor of the Exchequer.
Sweden	January 1993	2% (with a tolerance band of ±1%) in 1996 and beyond	CPI	Target set by the Bank of Sweden
Finland	February 1993	About 2% in 1996 and beyond	CPI excluding indirect taxes, government subsidies, house prices, and mortgage interest payments.	The target rate has no explicit band. Target set by the Bank of Finland.
Australia	1993	Underlying inflation of 2–3% on average, over the cycle	CPI excluding the impact of interest rates on mortgage and other interest payments, indirect tax changes, and certain other volatile price items.	Target set byt he Reserve Bank of Australia, and endorsed by the government, in the statement on the Conduct of Monetary Policy by the Treasurer and the Governor of the Reserve Bank
Spain	Summer 1994	Less than 3% by late 1997	CPI	Target set by the Bank of Spain.

1

For detailed analysis of inflation targets, including description of individual country cases, see the various contributions in Leonardo Leiderman and Lars E.O. Svensson, eds., Inflation Targets (London: Centre for Economic Policy Research, 1995); and G. Andrew Haldane, ed.,Targeting Inflation (London: Bank of England, 1995).

2

When the velocity of money is fully predictable, targeting monetary aggregates can be considered as a special case of inflation targeting, see Mervyn King, “Do Inflation Targets Work?”Quarterly Balletin. Bank of England, Vol. 35 (November 1995). pp. 392–94.

3

See John H. Green, “Inflation Targeting: Theory and Policy Implications.” IMF Working Paper 96/65 (June 1996).

The differences in average inflation rates among developing country regions in part reflect differences in fiscal performance. In particular, developing countries in Asia generally have experienced lower inflation rates than those in Latin America largely because of their greater fiscal discipline. Differences in fiscal discipline are not the only reason, however: the ability to adjust rapidly fiscal positions to external shocks is also a contributing factor. In this respect, the relatively more equal distribution of income in Asia compared with Latin America appears to make it politically easier in Asia to adjust fiscal policies rapidly.⁸¹

A further explanation for chronically high inflation is that institutions have developed that lessen the marginal costs of increases in inflation.⁸² In particular, the pervasive indexation of wages and prices in many countries partially insulates real activity from inflationary effects. Indexation, however, can also increase the ultimate cost of chronic inflation, since a longer lasting and deeper recession will be needed to lower inflation expectations that have become entrenched. A crucial policy lesson, therefore, is that countries should increase incentives for disinflation by modifying institutional features that reduce the costs of continued inflation and thus present obstacles to reform. In some countries, the development of financial markets and of indirect instruments of monetary control would help to insulate monetary policy from pressure to finance the fiscal deficit and would enhance the effectiveness of monetary policy.⁸³

Since the beginning of the period of transformation in 1989, annual inflation has at some point surged to triple-digit levels in nearly all the transition countries. A large part of the initial surge can be attributed to a one-time increase in the price level, which was necessary to absorb the monetary overhang immediately following the liberalization of prices. In countries that undertook stabilization programs early in the transition, such as Hungary, Poland, and the Czech Republic, inflation quickly stabilized following the adoption of firm stabilization programs, with falls in output being halted within two years. This pattern appears to be under way also in other transition countries that have more recently embarked on the stabilization process.⁸⁴

A factor that has contributed to the persistence of high inflation in many transition countries has been the continued need for relative price adjustments following the demise of central planning.⁸⁵ The process of convergence to free market prices has entailed dramatic increases in the prices of goods and services, such as fuel, food, housing, medicine, and health care, all of which were formerly heavily subsidized. The products whose prices have increased sharply account for a substantial portion of the consumer price index, and for the most part these price increases have not been offset by decreases in prices of other goods. As a result, these price increases have translated into concomitantly large increases in the average price level. Moreover, the process by which prices have adjusted has been prolonged in many transition countries, leading to continuing major adjustments of relative prices and associated increases in the overall price level. As the process of liberalization proceeds and the structure of prices in the transition countries converges toward that in the rest of the world, this additional source of upward pressure on prices would be expected to subside eventually.

Stopping High Inflation

A salient feature of the worldwide disinflation of the past ten to fifteen years is that it includes major episodes of stopping high inflation. These episodes are especially interesting in view of the sharp contrast between some of the observed outcomes and what had been expected, based on conventional wisdom about the output cost of stopping inflation. Instead of resulting in deep recession and high unemployment, most recent stabilizations from high inflation were associated with a sizable expansion of output and economic activity. The analysis and interpretation of these episodes can contribute to a deeper understanding of the inflation process and the policy measures that are effective in stopping high inflation.⁸⁶

Table 36 provides evidence from the various episodes of inflation stabilization during the 1980s and 1990s, defined here as a movement from a situation in which annual rates of inflation are above 40 percent for two years or more, to one in which annual rates of inflation are below 40 percent for two years or more.⁸⁷ Thus, instead of dating and defining stabilizations on the basis of official announcements, a results-based definition is adopted that is applied broadly to all countries. The table shows the rate of inflation in the year prior to the disinflation, the rate of inflation in the third year of the stabilization, and the rate of inflation in 1995.

Table 36.

Inflation and Output Growth Before and After Stabilization

(In percent a year)

Sources: Based on W. Easterly, “When Is Stabilization Expansionary?” (unpublished, World Bank, December 1995): and IMF, International Financial Statistics. Inflation rates are December-over- December percent changes.

¹The figure is for June 1995/June 1994.

²Output growth two years after disinflation.

Table 36.

Inflation and Output Growth Before and After Stabilization

(In percent a year)

	Peak Inflation	Year	Inflation Three Years After Stabilization	Inflation in 1995	Output Growth in Year of Peak Inflation	Output Growth Three Years After Stabilization
Argentina	4,923	1989	18	2	−6.3	8.6
Bolivia	8,170	1985	22	13	−3.6	3.4
Costa Rica	82	1982	11	23	−6.6	1.4
Dominica Republic	101	1990	3	9	−5.0	2.4
Ecuador	60	1992		23	3.5	3.91
Ghana	142	1983	33	71	−4.3	4.6
Guinea-Bissau	88	1992		492	3.7	6.91
Iceland	73	1983	14	2	6.1	8.5
Israel	445	1984	16	8	1.1	7.2
Jamaica	80	1991	27	26	0.8	4.5
Mexico	159	1987	30	52	2.3	4.9
Nigeria	65	1988	23	52	9.3	5.1
Nicaragua	7,483	1990	20	11	−0.6	1.8
Peru	7,650	1990	39	10	−4.7	5.8
Sierra Leone	115	1991	18	35	2.6	2.8
Turkey	86	1980	37	79	−0.9	3.6
Uganda	192	1987	22	11	2.6	4.8
Zaïre	101	1983	38	370	1.6	4.7

Sources: Based on W. Easterly, “When Is Stabilization Expansionary?” (unpublished, World Bank, December 1995): and IMF, International Financial Statistics. Inflation rates are December-over- December percent changes.

¹The figure is for June 1995/June 1994.

²Output growth two years after disinflation.

View Table

Table 36.

Inflation and Output Growth Before and After Stabilization

(In percent a year)

	Peak Inflation	Year	Inflation Three Years After Stabilization	Inflation in 1995	Output Growth in Year of Peak Inflation	Output Growth Three Years After Stabilization
Argentina	4,923	1989	18	2	−6.3	8.6
Bolivia	8,170	1985	22	13	−3.6	3.4
Costa Rica	82	1982	11	23	−6.6	1.4
Dominica Republic	101	1990	3	9	−5.0	2.4
Ecuador	60	1992		23	3.5	3.91
Ghana	142	1983	33	71	−4.3	4.6
Guinea-Bissau	88	1992		492	3.7	6.91
Iceland	73	1983	14	2	6.1	8.5
Israel	445	1984	16	8	1.1	7.2
Jamaica	80	1991	27	26	0.8	4.5
Mexico	159	1987	30	52	2.3	4.9
Nigeria	65	1988	23	52	9.3	5.1
Nicaragua	7,483	1990	20	11	−0.6	1.8
Peru	7,650	1990	39	10	−4.7	5.8
Sierra Leone	115	1991	18	35	2.6	2.8
Turkey	86	1980	37	79	−0.9	3.6
Uganda	192	1987	22	11	2.6	4.8
Zaïre	101	1983	38	370	1.6	4.7

Sources: Based on W. Easterly, “When Is Stabilization Expansionary?” (unpublished, World Bank, December 1995): and IMF, International Financial Statistics. Inflation rates are December-over- December percent changes.

¹The figure is for June 1995/June 1994.

²Output growth two years after disinflation.

The episodes considered include cases in which annual inflation rates were at extremely high levels of above 4,000 percent a year before stabilization, as well as cases in which yearly inflation was below 500 percent. Previous work has identified important differences between hyperinflation and chronically high inflation—differences that have vital policy implications for attempts to stop both types of inflation. Hyperinflations are characterized by the eruption of very high and rapidly accelerating rates of inflation, with inflation typically reaching monthly rates of 50 percent or more until the hyperinflation comes to an end. In these circumstances, nominal contracts tend to disappear and almost all prices are set and transactions effected in a foreign currency. Historically, hyperinflations occurred in some European countries in the aftermath of the two World Wars, when war- and postwar-related hikes in government spending induced large budget deficits that were primarily financed by monetary expansion.⁸⁸ In the sample in Table 36, there are four countries that underwent hyperinflation in the 1980s or early 1990s: Argentina, Bolivia, Nicaragua, and Peru.

In contrast to hyperinflations—which are shortlived—chronically high inflation may endure for years or even decades. Examples of high inflation include Colombia, Venezuela, Israel, and Turkey, all of which exhibited high double-digit, or even triple-digit, annual rates of inflation for a decade or more. Usually, chronically high inflation is associated with the existence of various indexation mechanisms for wages and nominal asset returns, and with substantially accommodative monetary and exchange rate policy, which contribute to the self-perpetuating and persistent nature of the process. They also reduce the costs of high inflation and thereby weaken the incentives for disinflation. High government budget deficits generally contribute to the development of chronically high inflation. Yet, theory and experience suggest that there are complex and dynamic relations between budget deficits and the rate of inflation, which may be reflected in apparently weak statistical links between these variables.

The differences between the two types of inflation processes have definite implications for stabilization policy. Historical experience indicates that policies to stop hyperinflation commonly include strong fiscal adjustment, drastic fiscal reforms, and the establishment of convertibility of the domestic currency in terms of gold or foreign currencies. Although in some cases convertibility of the domestic currency was set in conjunction with the adoption of a fixed exchange rate, in others it coexisted with a floating exchange rate. In the context of the chaotic situation at the peak of hyperinflations, the introduction of such fundamental fiscal and monetary reforms is likely to be perceived as highly credible, which will in turn contribute to the success of the policy. As regards the observed results, the two main stylized facts that emerge from experiences of stopping hyperinflation are, first, that there is an immediate and abrupt reduction in the rate of inflation, with price stability virtually achieved in a matter of a few months; and second, that low inflation is attained without deep recessions and sizable output costs. As a matter of fact, many episodes have exhibited negative output growth during the hyperinflation and an output recovery when the hyperinflation was stopped.

The highly persistent nature of chronically high inflation—and the fact that most countries have developed mechanisms (such as indexation and accommodation) to make living with it easier—have created unique difficulties for stopping it. In particular, disinflation by way of conventional fiscal and monetary contractions alone may be problematic in the short run because these policies alone cannot break the inertial elements of chronic inflation. Additional difficulties often arise owing to the failure of previous attempts to disinflate, which makes any new anti-inflation policies less and less credible. To overcome these difficulties, sharp adjustments in fiscal and monetary policies are typically supplemented by the adoption of nominal anchors aimed at dealing directly with the inertial elements of chronic inflation. Such “heterodox” stabilizations have usually been “exchange rate based.” with a fixed exchange rate serving as a nominal anchor, but with temporary wage and price norms typically performing a complementary function.

Among countries with chronically high inflation, recent well-known cases of exchange-rate-based disinflation are Israel (1985), Argentina 1985, 1991), Brazil (1986, 1994), and Mexico (1987). Conventional money-based stabilization policies—in which the money supply is the nominal anchor—have been implemented only in a few cases: to stop hyperinflation in Peru (1990) and, for a limited time, in Argentina and Brazil in 1990.

Most exchange-rate-based stabilizations have exhibited the following features:

(1) A marked but relatively slow reduction in the rate of inflation. Typically, it has been easier to disinflate from annual triple-digit rates to rates of between 10 and 20 percent a year than to reach the territory of single-digit annual rates of inflation. Accordingly, inflation rates in most previously chronically high inflation countries are still higher than those in industrial countries.

(2) A real appreciation of the domestic currency. To a large extent, this reflects the coexistence of a relatively stable nominal exchange rate and a positive inflation differential against trading partners.

(3) A deterioration in the trade and current accounts of the balance of payments.

(4) An expansion in the level of economic activity in the first few years following disinflation. In fact, economic growth is often weaker before than after disinflation (see Table 36). The finding that output growth is generally negative both in the year of peak inflation and right before disinflation begins supports the notion that stabilizations often are implemented only when the output losses from inflation become sizable and when some groups in society are willing to bear the fiscal costs of stopping high inflation.

Features (1) and (2) above have also characterized the less frequently used money-based programs to stop chronic inflation. But features (3) and (4) have not been as characteristic of money-based stabilizations. Indeed, some money-based disinflations have been associated with a marked slowdown in economic activity and with an improvement in the trade and current accounts of the balance of payments. The output response of exchange-rate-based and money-based stabilizations has not been definitively established, however.⁸⁹

Interestingly, the broad patterns and results of reducing chronically high inflation discussed above apply also to the stabilization experiences of transition economies in central and eastern Europe in 1990–94.⁹⁰ Most of these stabilization programs relied on at least two nominal anchors: the nominal exchange rate and wage norms. When coupled with fundamental (even if gradual) fiscal reforms, most of these programs brought satisfactory results, such as in Croatia, the Czech Republic, Estonia, Hungary, Poland, and the Slovak Republic. More conventional money-based stabilization programs were employed in fewer countries, and satisfactory results obtained only in some of these cases, notably, Albania, Latvia, and Slovenia. The success over the past year or so of money-based stabilization programs in most countries of the former Soviet Union, several of which informally fixed their exchange rates, however, suggests that it is the strength of and commitment to tight financial policies that matter most.

Despite the successful implementation of measures to stop high inflation in various countries in recent years, most of the countries concerned have not succeeded in eradicating double-digit inflation rates (see Table 36). As discussed below, one reason may be that it is hard to avoid some short-run output costs in bringing inflation down significantly farther. Another reason may be that in most of the moderate inflation countries, seigniorage is on the order of 2–3 percent of GDP and accounts for a significant share of government revenue. A shift to low single-digit inflation will require the fiscal problem to be tackled partly through tax reforms that make it possible to generate tax revenues at levels comparable with those of low-inflation countries and also through public expenditure restraint. Failure to pursue further disinflation may be costly, not least because of the risk that inflation may ratchet upward, with attendant costs in terms of low growth. This is most likely to be the case for inflation rates above the 30–40 percent range. When inflation exceeds that range, the probability that it will increase to triple digits rises sharply (Table 37).⁹¹ Nonetheless, the lessons learned in the design of disinflationary policies in high-inflation countries in the 1980s and 1990s should help these economies in future attempts to bring inflation down to single-digit levels at low output costs.

Table 37.

Probability of Inflation Being Above 100 Percent in Next Year at Different Rates of Inflation in Current Year

Source: Michael Bruno and William Easterly, “Inflation Crises and Long-Run Growth,” NBER Working Paper No. 5209 (Cambridge, Massachusetts: National Bureau of Economic Research. August 1995).

¹Calculated as number of observations in this range followed by 100⁺ percent inflation, divided by total number of observations in this range (pooled cross-section, annual data, 1961–92).

Table 37.

Probability of Inflation Being Above 100 Percent in Next Year at Different Rates of Inflation in Current Year

Range for Current Rate of Inflation	Probability of Next Year’s Inflation Being Above 100 Percent1
	In percent
Below 0	0
0–10	0
10–20	0
20–30	0
30–40	2
40–50	13
50–60	12
60–70	19
70–80	15
80–90	22
90–100	50
Above 100	71

Source: Michael Bruno and William Easterly, “Inflation Crises and Long-Run Growth,” NBER Working Paper No. 5209 (Cambridge, Massachusetts: National Bureau of Economic Research. August 1995).

¹Calculated as number of observations in this range followed by 100⁺ percent inflation, divided by total number of observations in this range (pooled cross-section, annual data, 1961–92).

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Table 37.

Probability of Inflation Being Above 100 Percent in Next Year at Different Rates of Inflation in Current Year

Range for Current Rate of Inflation	Probability of Next Year’s Inflation Being Above 100 Percent1
	In percent
Below 0	0
0–10	0
10–20	0
20–30	0
30–40	2
40–50	13
50–60	12
60–70	19
70–80	15
80–90	22
90–100	50
Above 100	71

Source: Michael Bruno and William Easterly, “Inflation Crises and Long-Run Growth,” NBER Working Paper No. 5209 (Cambridge, Massachusetts: National Bureau of Economic Research. August 1995).

¹Calculated as number of observations in this range followed by 100⁺ percent inflation, divided by total number of observations in this range (pooled cross-section, annual data, 1961–92).

Some Empirical Evidence on Factors Influencing the Inflationary Process

The monetary nature of sustained inflation is widely recognized. This principle is illustrated by the close relationship between the average rate of money growth and the average rate of inflation from 1960 to 1994 across a sample of 53 developed and developing countries (Chart 39). While money growth is the principle long-term determinant of inflation, the experience of the past thirty years shows that nonmonetary influences, such as commodity price increases, can play a role in triggering inflation. Charts 40 and 41 summarize the results of a study of the sources of inflation in developed and developing countries over the period from 1960 to 1992.⁹² The study compares the importance of various demand-side and supplyside influences on the inflationary process (Chart 40) and assesses the magnitude and duration of the response of inflation in reaction to an unexpected movement (a “shock”) in each of the determining factors (Chart 41). The supply-side influences considered are changes in oil prices, changes in non-oil commodity prices, and movements in nominal exchange rates.⁹³ while the demand-side factors include the growth of broad money, a measure of the gap between actual output and potential output, and past rates of inflation itself. Fiscal deficits are not included as a separate influence on inflation because they are likely to be subsumed in other factors: the accommodation of fiscal deficits is a principal cause of monetary growth in many high-inflation developing economies, while deficits in low-inflation industrial countries strongly influence aggregate activity as reflected in the output gap. The results show the empirical relationships between the six factors without imposing any constraints as to the particular channels through which the factors interact. Furthermore, the results are not very sensitive to changes in the assumptions made about the direction of causality between contemporaneous movements in the six influences of inflation, most notably the direction of causality between movements in money and output.

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Selected Industrial and Developing Countries: Inflation and Money Growth, 1960–95

(In percent change: annual averages)

There is a close relationship across countries between long-run inflation and long-run money growth.

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Influences of Various Factors on Inflation

Share of movements in inflation, which are explained by five factors at the horizons of 0–1 year, 3–5 years, and 10 years.

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Response of Inflation to Various Shocks¹

Response of inflation over a ten-year horizon to an unexpected movement (a “shock”) in the determinants of inflation.¹ The shocks are each one standard deviation in magnitude, and the peak response of inflation is scaled to equal 100.

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In both developed and developing countries, inflation was found to be very sticky: an unexpected increase in inflation resulted in a higher rate of inflation for four to five years in developing countries and ten or more years in the industrial countries. As discussed further below, the stickiness of inflation reflects several factors, including backward-looking expectations and indexation mechanisms. This persistence means that accommodation of inflationary shocks will have long-lasting effects, as the initial shock of a commodity price increase or an adverse movement in the terms of trade is propagated over time.

Perhaps surprisingly, oil and non-oil commodity prices directly account for only a modest portion of global inflationary movements. As discussed earlier, this may be due to the fact that the more important channels by which these shocks affect inflation are indirect, particularly through the use of monetary policy to offset the negative output effects from supply shocks that reduce potential output, and in the accommodation of the second-round effects on wages and prices. Nonetheless, the direct effects of shocks to oil and non-oil commodity prices on inflation are statistically significant, with the magnitude of the effects similar across industrial and developing countries. While commodity price shocks are not a pervasive feature of the economic environment, they clearly matter for inflation when they do occur.

The output gap accounts for a substantial portion of medium- and long-term movements in inflation in the industrial countries, with an unexpected increase in the output gap (i.e., a weakening of the economy) leading to a long-lived and statistically significant fall in inflation. This suggests that permanent changes in potential output, such as productivity movements and technological innovations, are important for inflation in the industrial countries, since fluctuations in demand over the business cycle would not be expected to have such a long-lasting effect on inflation. In contrast, the output gap explains little if any of the movements in inflation in developing countries as a group (see Chart 40). Note, however, that this represents the average effect of the output gap on inflation for a wide range of developing countries taken together, and this effect varies greatly across countries. Considered individually, there is a larger effect of the output gap on inflation in many countries in Asia, as in the results discussed in Box 3 in Chapter IV. Furthermore, in the developing countries as a group, an unexpected movement in the output gap has essentially no effect on inflation (see Chart 41).⁹⁴ Since the run-up in inflation in the 1970s and 1980s and the subsequent decline were much greater in developing countries than in the industrial countries, these results support the findings discussed above that inflation can be reduced from high to moderate rates at little cost in terms of lost output, but that it may be more difficult to reduce inflation at low levels where there is a short-term trade-off between output and inflation.

Conversely, changes in nominal exchange rates and money growth account for a larger share of the movements in inflation in developing than in the industrial countries. And an unexpected depreciation of the exchange rate or an unexpected increase in the rate of money growth has a longer-lasting effect on inflation in developing countries than in industrial countries. These results support the view that a disinflationary strategy in developing countries should include a combination of fiscal adjustment and tax reform to reduce the dependence on monetary financing, along with a commitment to a stable exchange rate regime. The importance of inflation expectations as seen in the persistence of inflation suggests that there is an important role for policies that lessen the scope of institutional features, such as wage indexation, that tend to contribute to their stubbornness.

Anticipated Versus Unanticipated Inflation

In analyzing the costs of inflation, a distinction needs to be made between anticipated and unanticipated inflation. It is widely acknowledged that the costs of fully anticipated inflation, which include the welfare costs of economizing on the use of money balances and the resource costs of periodic revisions of price lists (“menu” costs) are small, at least at low inflation rates. However, these costs are likely to be economically meaningful at high rates of inflation, especially at inflation rates sufficiently high to induce a demonetization of the economy. Then the costs are likely to be very high indeed, greatly exceeding estimates obtained from simple money demand calculations, because high inflation destroys social institutions and arrangements that simplify individual decisions and the coordination of activities. In particular, high inflation economies end up with a shrunken structure of intertemporal markets, with some markets disappearing altogether. In fact, this can occur not only at the very high rates of inflation that have been experienced in the postwar period only by some nonindustrial countries, but also at the more moderate rates of inflation experienced by industrial countries. For instance, the markets for long-dated, fixed-rate mortgages disappeared in some industrial countries in the late 1970s and early 1980s when inflation rates reached double digits. Because conventional estimates of the costs of inflation take no account of such disruption of market institutions and arrangements, they understate the true social cost.

The welfare costs of inflation are much higher when inflation is not fully anticipated. For inflation to be fully anticipated, all contracts, accounting systems, taxes, and other institutional arrangements would have to be fully indexed and adapted to it. In practice this is not possible; and attempts at widespread indexation have in most cases fostered higher inflation, with costs far exceeding the benefits of indexation per se. Tax systems are not fully indexed even in high-inflation countries; in industrial countries, tax systems are at best only partially indexed. Indeed, most industrial countries do not even issue government bonds indexed to inflation, though the number doing so is increasing (see Box 9). The interaction of inflation with a less than fully indexed tax system works to discourage capital accumulation, distort the allocation of capital among economic sectors, distort the allocation of lifetime consumption between early years and later years, and distort corporate and household financing and labor supply decisions.

The costs of these distortions depend on the institutional features of the economy. For the U.S. economy they have been estimated at 2–3 percent of GDP at an inflation rate of 10 percent, while a recent study has calculated that reducing the ongoing rate of inflation from 4 percent to 2 percent would result in a perpetual annual welfare gain of about 1 percent of GDP.⁹⁶ These costs, however, do not include some of the costs associated with the distortion of financial decisions. For instance, in many countries during the 1980s the interaction of inflation and tax rules resulted in low or negative after-tax borrowing costs, which contributed to excessive corporate borrowing and financial instability. In a number of countries, this resulted in large banking sector losses, increased the risk of systemic crisis, and led to the use of public funds to shore up problem-ridden financial institutions.

Owing to the absence of complete indexation, the costs of inflation do not fall equally across the population. Unanticipated inflation thus redistributes income and wealth: those on fixed incomes and with little wealth in the forms of real assets and foreign assets are made worse off, and negative real interest rates ex post mean that wealth is transferred from lenders to borrowers. Also, to the extent that inflation reduces the value of government debt and the real cost of servicing the debt, current holders of government debt lose while future taxpayers gain, so that there is an arbitrary redistribution of wealth between generations. Surprisingly little is known about the empirical, quantitative effects of inflation on income distribution. However, a recent study aimed at filling this gap found that both a higher and a more variable inflation rate tended to increase income inequality and that a negative effect of inflation on income distribution is more likely in countries with a less developed financial sector (Box 10).

Some of the major costs of inflation stem from the reduction in economic efficiency caused by increased uncertainty about future prices and the distortion of relative price signals. High inflation tends to be associated with increased variability not only of the aggregate price level but also of relative prices. Such increased variability, by increasing uncertainty about inflation and relative prices, has a negative effect on output.⁹⁷ It appears from Charts 42 and 43 that industrial countries that on average have had higher rates of inflation have tended to have more variable rates of inflation, and that countries with more volatile inflation have tended to have more variable output growth.

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Industrial Countries: Inflation and Inflation Variability, 1960–95

Greater volatility of inflation tends to be associated with higher levels of inflation.

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Industrial Countries: Variability in Inflation and Real Output Growth, 1960–95

Volatile inflation is associated with volatile growth.

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Effects of Inflation on Economic Growth

Inflation may not only reduce the level of output in an economy, notably by reducing the efficiency with which the factors of production are utilized, but it may also reduce the rate of growth of output, both by discouraging investment in physical and human capital, and by discouraging innovation and thus depressing the growth of total factor productivity. Even a small reduction in the growth rate will, over time, have substantial cumulative effects on output and welfare.

Empirical evidence shows consistently that inflation is negatively correlated with economic growth, and that the growth costs of inflation are economically significant. A number of estimates point to a reduction of economic growth in the range of 0.02–0.08 of 1 percentage point for a 1 percentage point increase in inflation.⁹⁸ The negative correlation between inflation and growth is most strongly apparent when economies with high rates of inflation are included in cross-country data (Chart 44) or when episodes of high inflation are included in time-series data. The relationship between inflation and growth at low rates of inflation is less clear. Some studies have found a negative relationship even at low single-digit rates of inflation, whereas other studies have not found a statistically significant negative relationship for annual inflation rates below 8 to 10 percent.⁹⁹ Be that as it may, a number of developing countries with average annual inflation rates of between 5 and 10 percent have been able to sustain rates of economic growth in the range of 5 to 10 percent a year. Another qualification is that the causality in the inflation-growth relationship has not been easy to establish, especially for low inflation rates. Not only may low growth be conducive to high inflation, but also the negative correlation may reflect the effects of third variables: thus, an adverse supply shock could simultaneously raise inflation and lower growth, and conversely for a favorable supply shock. Several conclusions emerge from this evidence. First, there is no support for the notion that higher inflation is beneficial for longer-term growth, although, as discussed further below, there is also no evidence that zero inflation is superior to very low positive rates of inflation. Second, the evidence is strongly indicative of a negative relationship between inflation and long-term growth, even at moderate rates of inflation of 10 to 30 percent. High rates of inflation are clearly harmful to growth. Growth falls steeply as inflation exceeds 30–40 percent and tends strongly to become negative at very high rates of inflation. The experience of the transition economies, in particular, shows that reducing high inflation has been a precondition for the revival of growth, and that stabilization leads to growth: specifically, it seems that annual inflation has to be reduced to less than 50 percent for growth to resume.¹⁰⁰ Third, even at the lower rates of inflation of 2–10 percent experienced by industrial countries over the past three decades, the greater variability of output associated with relatively higher inflation complicates the conduct of macroeconomic policy and increases the risk that relatively deep recessions may be required to stabilize the inflation rate in the event of overheating.

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Inflation and Real Output Growth, 1965–95

(In percent change; annual averages)

High inflation has generally been associated with poor growth.

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The above discussion is only one side of the coin. The other side is that there are also costs from deflation, that is, a declining price level. Although widespread deflation has not been experienced since the 1920s and 1930s, that experience clearly revealed that deflation—unanticipated or anticipated—is detrimental to economic activity. Unanticipated deflation, by increasing the burden of nominal debt and lowering borrowers’ net worth, can lead to defaults and financial distress, which depress investment and economic activity. Even if anticipated, deflation can have a depressive effect on the economy by reducing the attractiveness of holding real capital.

Asymmetric Effects of Economic Activity on Inflation

Analysis of the trade-off between inflation and output (or more precisely between inflation and the gap between actual and potential output) has often been based on the assumption that the trade-off is symmetric—that a rise in inflation caused by excess demand can be reversed without any net loss in output and employment. The implications of this are that stabilization policy cannot affect the average level of output and employment over the business cycle. Some recent research, however, finds that the relationship is asymmetric: that excess demand is more inflationary than excess supply is disinflationary.¹⁰³ Thus, any output and employment gains associated with an increase in inflation resulting from excess demand will be more than offset by the losses necessary to reverse the rise in inflation. The estimated degree of asymmetry for the major industrial countries is large enough for the net costs of allowing the economy to overheat to be quite significant. These are illustrated in Chart 45, which shows simulated responses of inflation and unemployment to an increase in excess demand that temporarily reduces the unemployment rate below the nonaccelerating inflation rate of unemployment (NAIRU) by 1 percentage point. The simulations are from an estimated model of the U.S. unemployment-inflation process and assume a NAIRU of 6 percent.¹⁰⁴

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Asymmetric and Symmetric Model Responses to Overheating

Effects of a decline in unemployment one percent below the nonaccelerating inflation rate of unemployment (NAIRU).

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When the inflation-unemployment relationship is asymmetric, a substantial increase in excess demand has a considerably larger effect on inflation than when the relationship is symmetric, and real interest rates have to rise by more in order to open up the correspondingly larger output gap needed to restore the inflation rate to its initial level. In both the symmetric and the asymmetric versions of the inflation-unemployment relationship, the unemployment rate returns to its initial level when the excess demand shock wears off. The cumulative effect on unemployment, however, is larger in the asymmetric version—by some 2 percentage points in this case. The cost of allowing the economy to overheat rises more than proportionately with the extent of overheating. The more an economy is allowed to overheat, the deeper or longer will be the recessions required to achieve a given inflation objective on average over a business cycle, and hence the higher will be the average rate of unemployment. Asymmetry becomes especially important when the economy operates at unemployment rates substantially away from the NAIRU. Close to the NAIRU, the inflation-output relationship is almost symmetric, so that the net costs of a modest degree of overheating are proportionately smaller.

Some important policy implications emerge from this analysis. First, asymmetry underscores the importance of avoiding excess demand pressures through preemptive steps to tighten monetary conditions before inflation starts to accelerate.¹⁰⁵ In this respect, it is notable that the raising of short-term interest rates in early 1994 in the economies most advanced in the current expansion, including the United States and the United Kingdom, stemmed inflationary pressures without major costs in terms of output and employment. This contrasts with the previous cycle in the late 1980s, when failure to act preemptively to avoid overheating resulted in a major slowdown in economic activity, particularly in European countries, when policy was eventually tightened.

A second implication is that a macroeconomic policy that avoids wide boom-and-bust cycles can, over time, result in a higher average level of employment and output than a policy that does not. Thus, it is particularly important to avoid substantial overheating, since the social costs of a deep and prolonged recession exceed the benefits of a boom of approximately equal magnitude.

Yet another implication is that the need for caution in the conduct of policy is reinforced by the unavoidable uncertainty about current and prospective inflationary pressures. Knowledge of potential output and the NAIRU is imprecise, and so is knowledge of excess demand conditions at any given time. This argues for the exercise of extra caution when an economy is at, or is fast approaching, potential.

Policies to Foster Disinflation

Policies adopted to reduce the costs of disinflation fall into two broad categories: structural policies, especially for labor markets, and measures to bolster the credibility of anti-inflationary policies, particularly by strengthening policymakers’ commitment to them. Such policies aim essentially to remove rigidities in actual wages and prices and to make the formation of inflation expectations less backward looking and more reflective of current anti-inflationary policy.

Structural policies have focused mainly on labor markets, aiming to increase wage flexibility and to promote market efficiency. Measures adopted have included active labor market programs to improve the employability of unemployed workers (e.g., training and placement), and regulatory and institutional reforms to enhance wage flexibility and remove disincentives to employment (e.g., changes to minimum wage laws and to regulations that affect the costs of hiring and laying off workers). In many instances, however, the structural reforms undertaken have tended to be piecemeal, minimizing their potential impact. As emphasized in Chapter III, broad-based labor market reforms continue to be needed, especially in Europe.

Measures to bolster the credibility of anti-inflationary policies have proceeded along several lines. One avenue has been to establish an explicit nominal anchor for monetary policy. Its purpose has been to tie down inflation expectations, and also to tie the authorities’ hands and exert a measure of self-discipline. Fixed exchange rates have long served this function for numerous countries, as discussed earlier. The ERM of the European Monetary System is the most prominent example among industrial countries; by tying their currencies to the deutsche mark, members of the ERM hoped to gain some of the Bundesbank’s credibility. Inflation rates among the members of the ERM have indeed converged to substantially lower levels than in the early years of the system, but the credibility gain is hard to assess, in part because inflation has also converged at low levels in non-ERM industrial countries. The ERM experience has also demonstrated that pegged exchange rates may be more difficult to maintain than previously thought. Increased international capital mobility has increased the vulnerability of pegged exchange rates to speculative attacks induced by perceived divergences in fundamentals. Furthermore, with downward price and wage rigidity, it may be difficult to bring about the real exchange rate adjustments necessitated by asymmetric real shocks. This may lead to devaluations or abandonment of the peg, or, if exchange rates remain fixed, result in higher inflation.¹⁰⁶

Countries opting not to fix their exchange rate often adopted targets for monetary aggregates. Monetary targets were widely adopted among the major industrial countries in the mid-to-late 1970s but were generally abandoned in the 1980s as relationships between targeted monetary aggregates and inflation broke down, partly owing to financial innovations.¹⁰⁷

More recently, explicit inflation targets have been adopted as the nominal anchor by a number of central banks. These have tended to be countries with histories of relatively high inflation. Central banks with well-established records of maintaining low inflation have not found the need to adopt explicit inflation targets, even though they have also found it useful to quantify their medium-term inflation goals. It is too soon to assess the role of explicit inflation targets in increasing credibility and lowering the costs of disinflation, since much of the period during which inflation targets have been in place has been characterized by a widespread easing of price pressures. Although the evidence thus far does not point to a detectable influence of inflation targets on the formation of inflation expectations, they may have helped to stabilize inflation expectations and to lower inflation-risk premiums.¹⁰⁸ The recent experience with inflation targeting shows that inflation targets will sometimes be missed. This suggests that establishing too narrow a target range may end up diminishing rather than enhancing credibility if the targets are too frequently breached by significant amounts and the overall inflation performance is unsatisfactory. Alternatively, credibility may be impaired if the public comes to believe that the costs of overly rigid adherence to an inflation target may be too high to sustain.

A second approach to enhancing credibility has been to change the institutional framework in which monetary policy operates. Here, the major development has been the general tendency toward greater central bank operating independence and toward the clear establishment of price stability as the central bank’s principal goal. Starting with New Zealand, several countries, including France, Spain, Chile, Mexico, and Venezuela have granted their central banks more independence, and discussions are under way in Japan. Also in the United Kingdom, increased transparency in the decision-making process and greater freedom for the Bank of England to make its views known publicly have served to increase somewhat the bank’s independence and power in the conduct of monetary policy. The purpose of greater central bank independence is to eliminate the possible inflationary bias of discretionary policy. The empirical evidence is that a country is more likely to have low inflation if the central bank is operationally independent (Box 11). Legal independence for a central bank is not sufficient, however, to ensure good inflation performance. A consensus is also necessary within society that low inflation is desirable. And as indicated earlier, cooperation between the monetary and fiscal authorities is essential.

Fiscal consolidation has been an important third avenue to enhance credibility. Markets tend to be skeptical of monetary authorities’ ability to pursue an anti-inflationary monetary policy in the presence of large budget deficits. Large budget deficits can lead to high real interest rates, rapidly growing public debt, and exchange market pressures. Especially in economies with high levels of public debt, as discussed above, an anti-inflationary monetary policy that is not supported by fiscal adjustment might not be credible.

What Constitutes Price Stability?

Several reasons have been advanced as to why the optimal inflation rate may not be zero. A long-held view is that a small positive rate of inflation enhances the efficiency of interindustry adjustments by facilitating relative real wage adjustments. Declines in real wages in a particular industry—and in the relative price of the particular good or service—can be brought about more easily through wage increases in other industries than through absolute declines in nominal wages in the industry concerned. Although nominal wage cuts are rare, this may not be as important a factor as it seems. This is because with productivity growing, real wage adjustments can be effected without nominal wage cuts even while maintaining zero inflation. Furthermore, total compensation may be more flexible than nominal wages. Firms can adjust their total compensation bill by changing benefits rather than nominal wages or salaries.

Another reason why zero inflation may not be desirable, which is an extension of the one above, is that it may increase the unemployment rate and correspondingly reduce the average level of output. A recent estimate for the United States has found the difference in the sustainable rate of unemployment between operating with a steady 3 percent inflation rate and steady zero inflation to be over 1 percentage point.¹⁰⁹ These estimates are derived from a model in which downward nominal wage rigidity constrains firms in their ability to make desired adjustments in real wages in response to changes in demand, resulting in inefficient reductions in employment. At low rates of productivity growth, the inefficiencies increase in significance as the rate of inflation approaches zero: the relation between inflation and unemployment is highly nonlinear at very low rates, so that targeting zero inflation may lead to unnecessarily high unemployment and large real costs to the economy. Since it is the sum of inflation and productivity growth that determines the number of firms constrained and the extent of the constraint, structural policies aimed at lessening nominal rigidities and boosting productivity growth will lower the optimal rate of inflation. In the absence of structural reforms, however, maintaining zero inflation may not be optimal.

Yet another reason why a policy of maintaining zero inflation may not be optimal is that a small positive rate of inflation enhances the efficacy of countercyclical monetary policy by allowing the short-term real interest rate to be negative, thereby increasing the potency of monetary policy during recessions. In a zero inflation environment, the best that the monetary authorities can do to mitigate the effects of an adverse shock to aggregate demand is to drive nominal and real short-term interest rates to zero. Such a reduction in the real interest rate, however, may not be sufficiently large to fully offset the negative effects of a large shock to aggregate demand.¹¹⁰ The importance of this argument depends on the nature of the monetary transmission mechanism, in particular the relative importance of the liquidity effect.

A final consideration is that official price indices are in many cases considered to overstate true inflation primarily because of unmeasured quality changes and the introduction of new goods, but also because of failure to properly account for substitution from goods whose prices have increased to other goods, substitution among retail outlets, and other biases. Estimates of the overall bias in the consumer price index range from 1 to 2½ percent a year for the United States and ½ to 1 percent for Canada, the two countries where the issue has received most attention.¹¹¹ Estimates of the upward bias in consumer price inflation in Europe, Japan, and other countries are not available, but it seems very likely that consumer price increases are overstated in those countries as well.¹¹²

In brief, there are analytical grounds for thinking that the optimal rate of inflation is not zero but is rather a small positive rate. Except for the negative real interest rate argument, however, they are not independent of the macroeconomic policies adopted nor of structural features of the economy that are themselves amenable to change. Measurement bias alone suggests that it may be prudent for central banks to aim for an inflation rate of 1–2 percent, at least until some of the measurement issues have been resolved and greater efforts have been made to remove structural rigidities in labor and product markets. Indeed, none of the countries that have announced inflation targets has set a target of zero inflation, and no central bank seems to be aiming at absolute stability of the price level. Instead, most have established target inflation ranges between 1 percent and 3 percent. In fact, even in the countries that have exhibited the strongest dedication to “price stability,” inflation rates over periods as long as a decade have generally not run below about 2 percent, and in no case has zero inflation over five years been achieved for any country in the postwar era.

How Far Should Anti-Inflationary Policies Be Pursued?

Economic principles suggest that a policy of disinflation should be pursued as long as the present discounted value of the social benefits from a further reduction in inflation outweigh the present discounted value of the social costs.¹¹³ Although definitive answers are impossible, in part because they involve discounting the welfare gains of future generations, a discussion of some of the factors that affect the analysis can shed some light on the problem.

The two most relevant factors to consider are whether inflation affects the potential growth rate of output and whether the costs of disinflation are permanent or transitory. If inflation has a depressing effect on potential growth, even by a small amount, then it is most likely that the benefits of bringing inflation down to low levels (in the 1 to 2 percent range) will outweigh the costs, since the cumulative output loss will be large. Similarly, if the output losses of disinflation are transitory, it is quite likely that they will be outweighed by the permanent benefits of reasonable price stability.

If, however, the unemployment and output losses of disinflation are permanent (or at least sufficiently long lasting to be considered permanent) and substantial, then the optimal rate of inflation will depend on the types of disturbance to which the economy is prone, and the starting point of the disinflation process. Clearly, the issue is empirical and cannot be resolved by economic theory alone. Nonetheless, insofar as nominal rigidities are a function of both economic policies and institutional structures and regulations, the optimal rate of inflation can be reduced over time by appropriate policies and structural reforms.

Box 11.

Central Bank Independence and Inflation

Increasing the independence of a country’s central bank can help to achieve and maintain low inflation. The principal reason is that a central bank that is endowed with a mandate to pursue price stability may thereby be better insulated from political pressure for lower interest rates or monetary funding of fiscal deficits, so that monetary policy will be more clearly oriented toward the medium-term objective of reasonable price stability. With an independent central bank, any political interference in the operation of monetary policy would have to be more transparent. Thus, a government that wishes to change the primary goal of monetary policy is forced to act openly by, for example, publicly instructing the central bank that it wants it to conduct a more expansionary monetary policy than is consistent with the central bank’s goal, or that it requires the central bank to provide deficit financing.

Increasing the independence of the central bank may promote low inflation, but it is not a panacea. It is one part of a set of institutions and reforms that can support the goal of price stability.

It is useful to distinguish two forms of central bank independence: goal independence and instrument independence.¹ Goal independence allows the central bank to choose the goals of monetary policy, rather than have them determined by the government or be legislated in the central bank’s constitution. The central bank could decide to pursue a goal of low inflation or a target rate of unemployment. Instrument independence lets the central bank pursue its goals (self-imposed or legislated) in the manner it deems most appropriate. The central bank is allowed to choose the timing and size of movements in its monetary policy instrument (e.g., a short-term interest rate). In a democratic society, it may be appropriate for the goals of the central bank to be set by the government, in which case the central bank should not have goal independence. To achieve price stability, however, the central bank, in addition to having price stability as its primary goal, must have instrument independence.

Greater independence of the central bank should not come at the expense of reduced accountability. Independence is meant to ensure that the operation of monetary policy is not affected by short-term political considerations. However, the central bank should be accountable to the government and the public for achieving its designated goal. In a number of countries (e.g., the United Kingdom, New Zealand, and Sweden), this accountability has taken the form of a quarterly or semiannual “Inflation Report” detailing the outlook for inflation and justifying the decisions taken on monetary policy in terms of the inflation objective.² In other countries, including the United States, the head of the central bank is required to testify on a regular basis before legislative bodies. The planned European System of Central Banks will be required first and foremost to achieve price stability. Without prejudice to that objective, it will be required to support the general economic policies in the Community, including the objectives of sustainable noninflationary growth and high levels of employment. The European Central Bank will have a constitution similar to that of the Bundesbank. Its independence will be enhanced by the appointment of governors for one eight year term only. It will be required to publish regular reports and to testify before the European Parliament.

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Industrial Countries: Central Bank Independence and Inflation

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The relationship between central bank independence and inflation has been extensively investigated.³ The chart above plots for selected industrial countries the average inflation rate from 1970–95 against an index of central bank independence. The index was calculated by assessing each central bank on a number of criteria, including its goals, its financial linkages with the government, and the procedure used to appoint the central bank governor.⁴ A higher score on the index indicates greater independence. Various studies have calculated indices of central bank independence, and although they arrive at somewhat different rankings from those shown in the chart above, they generally show an inverse relationship between the degree of central bank independence and the average inflation rate: the more independent a central bank, the lower the rate of inflation. The statistical significance of the relationship, however, hinges on the inclusion of data for the 1970s and 1980s. For the 1960s, and the 1990s, there is no clear relationship between the index of central bank independence and the rate of inflation. This suggests that one of the main benefits of an independent central bank may be in ensuring an appropriate response to the type of inflationary shocks that hit the world economy in the 1970s.

In interpreting these results two points should be noted. First, with pegged exchange rates, as in the 1960s under the Bretton Woods system, central bank independence is necessarily limited, and inflation rates tend to converge to that of the anchor country. Second, demand by the public for the maintenance of reasonable price stability may in fact be the most important guarantee of low inflation, but an independent and accountable central bank can nevertheless make an important contribution to that objective.

The relationship is not so robust for the developing countries, as shown in the chart on the right. For these countries, the correlation is not statistically significant.⁵ This finding may reflect the fact that any index of central bank independence is necessarily imprecise. The indices used in the empirical literature assess the independence of a central bank on the basis of its founding legislation and institutional structure. There may be a large divergence between such a measure of independence and the degree of independence that the central bank has in practice.

It should also be noted that the simple correlation illustrated in the chart does not take into account all aspects of the interaction between the central bank and the government. In particular, the central bank’s ability to pursue a goal of low inflation may be severely curtailed if a large fiscal deficit requires monetary financing, even if it has a high degree of independence by many criteria. Increasing the independence of the central bank may be futile if there is not also fiscal reform. At the same time, a more independent central bank may exert discipline on the fiscal authorities.

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Selected Developing Countries: Central Bank Independence and Inflation

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The reform of the Reserve Bank of New Zealand suggests some guidelines on increasing central bank independence. The primary goal of the bank is to achieve price stability. This goal is not set by the bank itself, however, but by an agreement, the Policy Targets Agreement (PTA), between the finance minister and the governor of the bank. That is, the bank does not have goal independence. It does, however, have full instrument independence, as it has complete control over the determination of official interest rates. Moreover, the governor is directly accountable to the minister of finance for the achievement of the PTA. The performance of the governor is monitored by the board of the bank on behalf of the finance minister. The board in turn reports to Parliament. Thus, while maintaining a high degree of independence, the bank is also highly accountable for its actions.

While the New Zealand experience suggests that increased central bank independence facilitated the achievement of low inflation in recent years, a number of other industrial countries without increased central bank independence also experienced significant declines in inflation.⁶ Furthermore, increasing the independence of the central bank did not ensure a costless disinflation: New Zealand underwent a large recession during its disinflation. The increased independence of the bank, however, may have reduced the cost of the disinflation below what it would otherwise have been by increasing the credibility of monetary policy, and it is likely to assist in the maintenance of low inflation.

1

This distinction was introduced by Guy Debelle and Stanley Fischer, “How Independent Should a Central Bank Be?” Goals, Guidelines, and Constraints Facing Monetary Policymakers, Conference Series No. 38, ed. by Jeffrey C. Fuhrer (Boston, Massachusetts: Federal Reserve Bank of Boston, 1994)

2

In the United Kingdom, accountability is also enhanced by the publication of the minutes of policy meetings between the Governor of the Bank of England and the Chancellor of the Exchequer. The Chancellor is, of course, accountable to Parliament.

3

See, for example, Vittorio Grilli, Donato Masciandaro, and Guido Tabellini, “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries,” Economic Policy: A European Forum, Vol. 6 (October 1991), pp. 342–91; Alex Cukierman, Central Bank Strategy, Credibility and Independence: Theory and Evidence (Cambridge, Massachusetts: MIT Press, 1992); Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparitive Evidence,” Journal of Money, Credit and Banking, Vol. 25 (May 1993), pp. 1–14.

4

The index reflects institutions and legislation as of the late 1980s. Changes in some central bank statutes since then alter the index illustrated in the chart.

5

A negative correlation between inflation and central bank independence has been found for developing countries when the rate of turnover of the central bank governor is used as a proxy for independence. This may simply be capturing the effect of general political instability, however. See Alex Cukierman, Steven B. Webb, and Bilin Neypati, “Measuring the Independence of Central Banks and Its Effect on Policy Outcomes,” World Bank Economic Review, Vol. 6 (September 1992), pp. 353–98.

6

See Guy Debelle, “The Ends of Three Small Inflations: Australia, New Zealand and Canada,” Canadian Public Policy, Vol. 22 (March 1996), pp. 56–78.

Policies for Maintaining Price Stability

Inflation rates in industrial countries, as well as in a number of developing countries, have declined to their lowest levels in decades, and in a number of industrial countries are at rates close to, or approaching, reasonable price stability. With appropriately designed monetary and fiscal policies, it should be possible to keep inflation low and to reduce it further over time, while minimizing undesirable short-term fluctuations in output. The U.S. Federal Reserve in particular has emphasized the importance of preventing inflation from rising significantly during economic expansions while taking advantage of economic slowdowns to bring inflation down, and thus allowing a ratcheting down of inflation over the course of successive business cycles until price stability is achieved.¹¹⁴

The decline of inflation in recent years is partly the result of a changing global economy. But most important, it is the result of determined policy actions to bring inflation under control. Increased openness to trade has been a beneficial influence on inflation. Liberalization of trade restrictions typically results in lower prices of imported goods and thus provides competitive discipline for domestic firms. In countries with inefficient or monopolized industries, this can result in a lowering of price-cost markups.¹¹⁵ Globalization has the further beneficial effect that the introduction of advanced production techniques from foreign firms can lead to increased productivity and output growth, particularly in developing countries.¹¹⁶ However, these effects from openness and globalization are likely to provide one-time downward shifts in the price level rather than act as permanent restraints on the rate of inflation. Moreover, markets in many industrial countries are already quite competitive, so that added competition from foreign firms tends to have only limited effects on the pricing environment.¹¹⁷ Such forces as trade liberalization are thus unlikely in themselves to provide long-lasting changes in inflation, notwithstanding their beneficial effects on resource allocation and economic efficiency. Nonetheless, economies characterized by greater openness to trade have generally experienced lower rates of inflation; this suggests that institutional features, such as openness, that increase the costs of inflation can induce countries to favor policies that lead to lower inflation.¹¹⁸

What provides the greatest hope for the future, however, is that a large part of the recent decline in inflation can be attributed to the adoption of sustained noninflationary policies. Despite initial hesitation and policy mistakes, governments and central banks have applied the hard-learned lessons from the high-inflation decades of the 1970s and 1980s with increasing success. Foremost among these lessons is the importance of stopping inflation before it gains momentum. The global experience of the past thirty years has shown that the short-run costs in terms of unemployment and lost output of preemptive actions to arrest incipient rises in inflation are likely to be far smaller than the long-run costs of allowing inflation to rise to double or triple digits. Expectations of future inflation are important determinants of current inflation—thus, establishing credibility in the fight against inflation is crucial. A central bank that too readily trades its credibility for short-term gains in output will soon find that the short-term gains disappear, leaving only worse inflation to combat. In contrast, a central bank that firmly establishes and maintains its anti-inflationary reputation will likely garner a “credibility bonus,” so that the effectiveness of monetary policy in preventing undesirable variations in output will be enhanced. The challenge, of course, is to find the appropriate balance between determined action to stop inflation and policies that will ensure the stability of employment and output.

Monetary policy alone cannot and should not bear the burden of achieving and maintaining price stability. Structural policies, especially labor market policies, that reduce wage and price rigidities and enhance competition, and sound fiscal policies and low public debt levels are essential elements of a sustainable anti-inflationary policy strategy. In recent years, many countries—industrial, developing, and transition economies—have made substantial progress toward reducing excessive fiscal imbalances. But, as discussed in the May 1996 World Economic Outlook, budgetary imbalances remain a source of upward pressure on real interest rates in industrial countries and further progress toward fiscal consolidation is essential, especially in view of the budgetary pressures associated with aging populations. Similarly, in developing and transition countries, fiscal deficits are still too large in many cases and remain a threat to the sustainability of recent reductions in inflation.

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Restoring a high degree of price stability has been a central objective worldwide. It has now been achieved or is within reach in most countries. Safeguarding this achievement is essential. It is first and foremost—albeit not exclusively—the responsibility of monetary authorities. While the rewards in terms of output growth in any one year may seem small, the cumulative effects on levels of output and living standards are potentially considerable.