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Leijonhufvud, A., “Costs and Consequences of Inflation,” in Information and Coordination (New York: Oxford University Press, 1981).
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Work on this paper started while the author was working with the Pacific Division of the Western Hemisphere Department. Helpful comments and suggestions by Charles Adams, who identified one important flaw in the analysis, Peter Clark, Luis Duran-Downing, Jorge Guzman, Martin Hardy, Bennett McCallum, and Robert Rennhack are gratefully acknowledged. The views expressed are those of the author and do not represent those of the International Monetary Fund.
The adverse effects of inflation on the distribution of income between creditors and debtors and on the degree of uncertainty affecting credit markets have been a cause of concern for a long time (see Mill (1848) Chapter XIII). Two classic papers on indexation and the costs of inflation are Friedman (1974) and Gray (1976). For a textbook discussion of financial indexation, see Gordon (1978), and for wage indexation, see Parkin and Bade (1986). The advantages of financial indexation are explored from the perspective of the more recent intertemporal equilibrium approach by Calvo and Guidotti (1989). The risk of indeterminacy of the price level due to excessive inertia and other issues regarding the public’s aversion toward indexed contracts and the determination of the relevant price index are reviewed by Leijonhufvud (1981).
A stronger version of this critique, as explained by Leijonhufvud (1981), argues that because indexation is equivalent to forcing price expectations to exhibit unitary elasticity, any small price change could cause an exploding inflationary spiral. However, advocates of financial indexation have shown that although changes in inflation are likely to be larger in indexed economies, the price level and inflation are well-defined and stable as long as the supply of money is not fully indexed (see Parkin and Bade (1986)).
Critics of indexation would argue that the social costs of the redistributive effects that occur when interest rates are not indexed are less important than those that occur under a partial indexation system. Issues related to income redistribution and its social cost are not addressed in this paper.
The ex post real interest rate on a 90-day indexed time deposit entered at date t is computed as the difference between the effective yield, which is the sum of the premium over UF quoted at t plus the change in the value of the UF in the 90 days following t, and the inflation observed 90 days after t. The premium over UF is quoted in annual terms and compounds monthly. The rates in Figures 1-3 are returns over a period of three months.
These regulations are consistent with some of the recent literature on monetary legal restrictions, e.g., Smith (1988), in which restrictions serve the purpose of preventing the private sector from issuing close substitutes of money so as to avoid large price fluctuations and adjustments in financial markets.
These policies included the intervention and closing of banks, the provision of massive liquidity support by the Central Bank, the temporary public guarantee of bank deposits, the establishment of credit lines in support of private debtors, and a program of recapitalization based on voluntary sale of a fraction of bad loans to the Central Bank.
Daily adjustments in the UF on the basis of the inflation from the previous month have been undertaken since 1977. The UF was first introduced in January of 1967 under a system of quarterly adjustments.
The secular growth in deposits with more than 1 year maturity reflects the growth of deposits from the pension funds, which should not be viewed as pertaining to the private sector but to nonbank financial intermediaries.
Deposits in U.S. dollars are allowed for maturities of 30 days or longer, with adjustments in the exchange rate of the Chilean peso vis a vis the U.S. dollar that fluctuate around the difference between the movement of the UF and an estimate of foreign inflation. During the period January 1986-May 1990 these deposits were equivalent to less than one third of the total of deposits denominated in Chilean currency.
A similar result is obtained from the data on total daily banking operations of time deposits.
These rates are published in annual terms, but in evaluating equation (1) care must be taken of the fact that they are compounded monthly.
This paper focuses on market efficiency when expectations are formed on the basis of publicly available information, which in the finance literature is viewed as semi-strong market efficiency since it ignores the role of “inside” information. However, the role of inside information in the market of bank deposits is likely to be limited.
The numbers in brackets in all regression results are “t” statistics; those marked as * are significant at the 5 percent level and those marked as + are significant at the 10 percent level. The hypothesis of zero autocorrelation of regression residuals was tested using the method of Box and Jenkins. All relevant regression output is included in a technical supplement available upon request.
However, by estimating an ARMA(2, 1) process, it can be shown that the restriction that the two autoregressive terms are zero cannot be rejected by the data at the level of 5 percent significance (the corresponding F-statistic is F(2, 27) = 3.363).
Other variables dated t or earlier, such as the inflation rate, the exchange rate, the UF and the ex ante yields of indexed and non-indexed time deposits, were introduced to the equation to confirm that they do not convey any significant additional information.
The restriction that the seasonal adjustment parameter is zero is clearly rejected by the data at the 1 and 5 percent significance levels (F(1, 30) = 15.21).
This conclusion would not follow if the UF moved exactly with inflation month by month. In this case, the dependent variable in (8) collapses to -Pt, 30 and the UF premium becomes identical to the ex ante real interest rate.
Note that the spread of interest rates is a useful indicator of the stance of monetary policy, but is not an instrument nor a target. The size of the spread per se does not indicate the extent of the adjustments that are necessary in instruments and targets, it only informs the authorities of the market’s perception regarding monetary policy stance.
The issue here is not how tight the Central Bank designs monetary policy, but how individuals in financial markets perceive it. Thus, it does not suffice that the authorities design a theoretically sound anti-inflationary policy; the reputation and credibility they command in financial markets also play a crucial role.