Question

(a) If inflation has economic costs, why don’t central banks have a target of zero inflation?

Following the GFC in 2007-08, a number of economists have called for central banks to raise their inflation targets to 4 to 5 percent as a way of reducing the risk of hitting the zero lower bound (ZLB).

(b) How does a higher inflation target help to reduce the risk to a central bank of hitting the ZLB? (Hint: Use the Fisher effect.)

(c) Recently some central banks have set negative values for their policy rates (e.g. Sweden, Japan). To what extent is such a strategy an alternative to higher inflation targets.

Answer 1

a.)

Inflation can defined as the rise in general price levels over a period of time. There are numerous economic costs associated with inflation which include a decline in competitiveness due to increased prices, menu costs are incurred as prices change, households in the economy will also experience a fall in the real value of savings along with potential fall in real income which may negatively affect the consumption expenditure component of aggregate demand. But it is not advisable for central banks to have a target rate of inflation of zero because a certain level of inflation poses as a good indicator of economic growth and stability. Demand-pull inflation is a signifies a healthy economic environment, and as fundamental economic theory states, there is demand increases only when the desire and more importantly the willingness of to purchase goods are services increases, as this increases the price levels increase, and this will only increase if the economy is growing. Therefore zero inflation is not recommended because zero inflation could mean a lack of economic growth and an economy deprived of consumer confidence, whereas a positive inflation rate despite its costs is desirable.

b.)