Fiddling with Monetary Policy

July 4th, 2008 at 3:02 pm by David Farrar

It is a sign of the desperation in Labour’s ranks that both Mallard and Cullen are now hinting at abandoning the 20 year consensus on being used to keep inflation low.

Using the cash rate to keep inflation low is not perfect. People accept that. In fact one of the best criticisms I have seen of the model came at the Business Roundtable Retreat of all place.

But just as Winston Churchill said democracy is the worst way to choose a Government, except all the other way – the same tends to apply to monetary policy.

Despite what WInson Peters says, there is no evidence at all that having higher inflation will lead to lower unemployment. We have emperical evidence for this in NZ, where we have had one of the lowest unemployment rates and low inflation.

If you go easy on inflation, you may get a short-term economic boost, but in the medium to long-term you are worse off. This is why almost evert OECD country has a similiar monetary policy to New Zealand. Only fringe dwellers seriously disagree with the basics.

Now as I said the status quo is not perfect. The question is whether one can find a better solution. The Visible Hand in Economics is canvassing that issue.

The most appealing proposal I have seen is from Don Brash who has an unorthdox solution that the Reserve Bank be given an additional weapon or lever – the rate of petrol tax. Brash advocates that as petrol consumption is fairly price inelastic, an increase or decrease in petrol tax could warm up or dampen the economy in a similiar way to changing the cash rate. But with the benefit that exporters are not so badly affected by the exchange rate going up due to higher interest rates.

There are constitutional issues around such a move (Brash suggests over the long term it would have to be revenue neutral so the RBNZ is not making profits from it).

I certainly think it is an idea worthy of study. My initial question (and I would love it if an economist could crunch some numbers) is how much would one have to increase or decrease the rate of petrol tax to be equal to say a 25 point change in the cash rate?

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38 Responses to “Fiddling with Monetary Policy”

  1. tim barclay (886 comments) says:

    Controlling inflation though the cash rate is the only instrument the Reserve Bank has. The Government has everything else. But in Cullen you have a Minister who does not see that his actions are putting cost push inflation through the economy. Rather than address that (and it is too late now) Cullen tries to manipulate things in the short term so that the man who has caused interest rates to DOUBLE is trying through some slight of hand to engineer something in the short term. The man is clever and dangerous which is a bad combination.

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  2. dog_eat_dog (677 comments) says:

    Exactly. I am all for experimental monetary policy, at least it will get it out of the hands of inept politicians. There are plenty of tools we can use to control inflation, and in an ideal, technically advanced economy, we could have a variable rate of GST, which would be the purest and most direct way to control inflation. But unless the government is prepared to foot the bill to update book-keeping software and point-of-sale devices (and I really wish they would just do it), a variable rate of GST is a thing of dreams. So we need other measures. Hopefully Dr Brash’s suggestions aren’t just wiped away – he’s a very very smart man and definitely someone we would be foolish to ignore.

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  3. berend (1,600 comments) says:

    Not PC explained inflation. The summary: you only get inflation when the government prints money.

    And many economists agree. So that’s why Brash’s approach won’t work. If you don’t know what causes inflation, how ever can you come up with a solution for it that works?

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  4. david (2,482 comments) says:

    But berend, a tax increase (if not accompanied by an increase in government spending) is exactly the reverse of putting more money into M1 the money supply. The effect should be a reduction in inflation, a bit of price depression (ie less money chasing the same amount of goods and services.) Cullen has had the keys in his hands for 9 years but has spent the surpluses and blown any chance of managing the economy effectively.

    For him to somehow say the the Reserve bank has failed and needs to change the targets is a rich irony indeed and can only be described with one of two words. Either IGNORANCE or HYPOCRACY. You call it.

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  5. dime (8,751 comments) says:

    “Not PC explained inflation. The summary: you only get inflation when the government prints money.

    And many economists agree. So that’s why Brash’s approach won’t work. If you don’t know what causes inflation, how ever can you come up with a solution for it that works?”

    so if we all cut our spending by 20% and saved it, that wouldnt impact inflation?

    if everyone withdrew their savings and spent it, that wouldnt impact inflation??

    sounds a bit dodgy to me ;)

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  6. Bryan Spondre (554 comments) says:

    “Despite what Winson Peters says, there is no evidence at all that having higher inflation will lead to lower unemployment. ”

    Given that Winstons constituency are the retired why is pushing this particular barrow ? Surely he must know that the retired will suffer most from high inflation.

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  7. Bryan Spondre (554 comments) says:

    tim: “Cullen tries to manipulate things in the short term” Surely Cullen is unable to change the Reserve Bank Act prior to the election ?

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  8. berend (1,600 comments) says:

    david/dime: I’m talking about the increase in money supply. The government can print as much as it wants, that’s the trouble.

    More on money supply here.

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  9. berend (1,600 comments) says:

    And this from NZ’s Foundation for Economic Growth:

    In 1988 our M3 money supply amounted to some $43,101 million. Twenty years later our M3 money supply had expanded to $201,273 million.
    This is an annual compound interest rate of around 8%.
    No wonder we are experiencing inflation.

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  10. dime (8,751 comments) says:

    who controls the printing of money? which govt dept?

    how much do they print per year? do they explain why they are printing said amount?

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  11. JC (838 comments) says:

    It seems to me that if you damn near double Core Govt Expenditure in 9 years.. and to little good, then you’ll get a host of economic problems, including inflation.

    JC

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  12. berend (1,600 comments) says:

    Some more, because if we don’t understand inflation, we won’t be able to fight it:

    Since Labour has been in power the money supply (M3) has increased from $98,520m (Aug 1999) to $190,913m (Aug2007). This is an increase of $92,393m or 94% in eight years and of course it has produced inflation.

    This shows up mainly in houses. Has your house doubled in price in the last 8 years? What is really happening is that as the government prints paper money and issues credit(debt to us) its value falls. If the print enough its value fals by half. Your house has not doubled in value. The value is much the same as it has always been. It is just that the new dollars that the government is printing are only worth half as much as they were in 1999.

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  13. adc (520 comments) says:

    berend

    that analysis is seriously flawed.

    It assumes that people can eat oil if that’s all they have money for.
    or that they won’t go into debt etc.

    I’ve often thought though that it would be cheaper for the economy to suffer inflation instead of tax. E.g. abolish all tax, and just get the govt to print money for public spending. Then you don’t have to fund the IRD, or all the accountants in all the companies, and those people can go get productive jobs. Save billions and billions on compliance costs for tax, and the down-side of a bit of inflation.

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  14. berend (1,600 comments) says:

    adc, may I quote Frank Shostak?

    In the modern world, money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money. Please note we don’t say, as monetarists do, that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

    Read that article to get some understangi of the subject instead of saying “seriously flawed”. Maybe quote an economist like Keynes or Paul Krugman to back you up.

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  15. homepaddock (429 comments) says:

    The most disturbing aspect of this is that Labour is putting short term political gain ahead of the national interest. In doing so they’re also abandoning the principle that monetary policy should not be a political plaything. They made no attempt to get bi-partisan support for the EFA and it looks like they’re willing to forgo it with monetary policy in an attempt to woo Winston too.

    Pity we don’t have a Political Responsiblity Act.

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  16. Bernard Hickey (19 comments) says:

    Making monetary policy a political issue is dangerous for New Zealand, given our currently precarious debt position. Here’s why.
    http://www.interest.co.nz/ratesblog/index.php/2008/07/03/opinion-i-smell-blood-in-the-monetary-policy-water/

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  17. Rex Widerstrom (5,124 comments) says:

    berend, I’m certainly not an economist but your assertion (or rather that of Shostak) certainly seems to make sense. It also seems obvious that once the value of money became decoupled from the gold standard, and became measured instead against the nominal value of other pieces of paper, then the potential for inflation became much higher.

    This piece of Shostak’s essay particularly resonated, however:

    When money is expanded — i.e., created out of “thin air” — the holders of the newly created money can divert to themselves goods without making any contribution to the production of goods. As a result, wealth generators who have contributed to the production of goods discover that the purchasing power of their money has fallen…

    …particularly in light of your quoted statistic of a rise of 94% in the money supply under Labour. So let’s see if we can put Shostak’s view into a New Zealand setting:

    “The Labour government created money out of thin air, much of which has been used to remunerate those who do not make any contribution to the production of goods: treaty workshop facilitators, hip hop researchers, revenue-gathering traffic cops, spin doctors, workplace relations consultants, bureaucrats armed with stultifying volumes of regulations, DHB managers, the Ministry of Womens Affairs, the Ministry of Youth Affairs, electricity company managers etc etc. As a result, workers who have contributed to the production of goods – a.k.a. Labour’s traditional support base – have discovered that the purchasing power of their money has fallen…”

    Perhaps that, Bryan Spondre, is the constituency Winston is trying to reach out to again. We didn’t NZF to 30% in the polls purely on the votes of retired people, you know. I went and listened at places like the Petone Workingmen’s Club and the Naenae RSA – places packed to ceiling with Labour’s support base – and devised policies aimed at them. The comments Winston is making today about inflation vs employment are the result of a few scattered memories of his pre-bauble days occasionally firing his synapses. Pity it’s 10 years too late.

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  18. tim barclay (886 comments) says:

    Cullen could alter the policy target agreement and say have a 5% target which would allow interest rates to fall in the short term. I assume he will try and engineer so he can say look look look even though I have doubled interest rates they are now coming down.

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  19. Michael E (274 comments) says:

    Rather than a petrol tax, BNZ economist Tony Alexander proposed a fixed mortgage rate levy last year. In essence, all fixed rate mortgages would be like floating mortgages with increases and decreases set by RB policy.

    When the Official interest rate / OCR was first instituted, most mortgages were variable and changed with Reserve Bank pronouncements. So at the moment the effects of OCR changes take much longer as people take fixed term rates and could be 2-3 years before the rise hits in the pocket.

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  20. kiki (425 comments) says:

    Why not zero income tax. Taxes on other things like GST, capital gains and a little bit of company tax. User pays for most things with the government helping the truly poor.

    A large part of the problems we and other western nations are in is due (I think) to the ability of the governments to dip into the workers pocket virtually sight unseen and then spend.

    This creates a situation where people don’t see a connect between their actions and costs which encourage the government to keep on spending. This isn’t just things like working for family welfare but also business’s who quietly line up to receive our cash. If you look around a lot of business groups are starting to put their caps out so the tax payer can subsidize them.

    Where this burble is going is that if the tax system offers little benefit for gains such as claiming tax and projects that need doing are funded by actual charges then money would generally go to where the profit is with out tax distortion, project spending would be constained by the actual return, houses included. The money just would not be there for the government to give away.

    Another factor that no one seems to mention is the extra things that the gov has handed out. Now as a worker I like flexi-time, four weeks leave, increases in minimum wage and removal of youth rates as well as maternity pay, OSH regulations and equal opportunities but (always a but) I would guess some one has to pay for these things, I can only guess how many percent this all adds to our costs.

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  21. paradigm (507 comments) says:

    Berend, respectfully the other posters are correct in the assertion your analysis is flawed. You are quite correct that printing money will cause inflation, however this is NOT the only thing that will cause inflation by any stretch of the imagination. High demand relative to a low supply also causes inflation: If a quantity demanded outstrips the amount available then in the short term, suppliers will sieze the opportunity to make as much money as possible by increasing the price. This will cause some not to buy the good, however this is irrelevant to the supplier until the price gets so high that less goods are demanded than the total available for sale (the supplier will still be able to sell his entire stock until this becomes the case). Hence we establish that increases in demand or decreases in supply both cause a rise in prices; if either occur as a general trend inflation will result.

    I take strong exception to the reasoning found in the not pc article:
    “If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people’s money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down.”

    This is rubbish as it assumes we spend our entire income on consumption and do not save any. What will actually happen (especially to those in the middle class and above) is that the amount of money saved will decrease, the amount spent on consumption will increase. Also in the longer term higher prices tend to increase pressure for wage increases. When wages increase without a corresponding increase in production, more money is given for the same amount of worker output, ie the price of labour increases. This is in its self inflationary, however we should also consider that in order to pay for the wage increase, the employers are forced to increase their prices. Once again inflation happens.

    What I think we do need to differentiate between is supply driven inflation, which is caused by increasing scarcity of resources such as oil and demand driven inflation, often caused by cyclic booms in various sectors of the economy and/or the imperfect knowledge of consumers and producers. The latter should be smoothed by the monetary policy, however it may be more efficient to leave the former the way it is.

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  22. expat (4,048 comments) says:

    Or are Duckman and PoodleBoy trying to flush the Nats policy re:reserve bank act out before the election so they can attack it? Probably…

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  23. berend (1,600 comments) says:

    paradigm, increase in price due to demand and lacking supply isn’t inflation. That’s the whole problem here: with a wrong definition of inflation, any countermeasures will have the famous unintended consequences for which governments are so well-known.

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  24. OECD rank 22 kiwi (2,786 comments) says:

    Is Labour conducting a scorched earth policy?

    It seems determined to commit economic sabotage. That’s impressive given all the damage it has already achieved over the last nine years. New Zealand just keeps on sliding down the OECD ladder. Don’t people see the falling living standard in New Zealand or are high fuel costs preventing Kiwi’s from travelling overseas and seeing for themselves?

    Labour party MP’s should be prosecuted for treason for what they have done to the New Zealand economy.

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  25. Patrick Starr (3,675 comments) says:

    Off topic but ‘Fiddling’ was the closest tag

    It appears the Mystery man in Winston Peters life has been exposed !

    “Print one thing wrong, sunshine, and I will sue you,” Mr Peters said before hanging up.” http://stuff.co.nz/4608002a19715.html

    vintage Peters stuff -excellent

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  26. paradigm (507 comments) says:

    Berend said:
    “increase in price due to demand and lacking supply isn’t inflation.”

    Respectfully, I must disagree: As I suggested earlier, increase in price from high demand will inevitably cause labour to demand higher wages. We can then describe the situation as follows: Workers are now paid more for the same production output AND it now costs more for to purchase the same goods, services. In short the value of money has decreased.

    You are actually correct in that if one was to restrict the money supply, the scarcity of money should counteract inflationary pressures; however to do so would be economic suicide. If money becase scarce businesses and people seeking loans would often be outright turned down. New busnesses would then become difficult to start and current businesses could not finance capital aquisitions. Economic activity would grind to a halt. Currently we tollerate a degree of inflation as it allows the economy to operate efficiently. Draconian control of the money supply could prevent inflation but at the cost of shutting the modern economy down. One would also suffer a problem of knowing exactly how much to restrict the supply of money…

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  27. MacDoctor (66 comments) says:

    Paradigm is absolutely right. The traditional definition of Inflation is “too much money chasing too few goods”. On one side of that equation is the money supply, on the other side is production. In order to prevent inflation, any increase in the money supply needs to be met with a corresponding increase in productivity. This is precisely why government spending is so inflationary, because it tends to be spent on non-productive items, when it is spent on anything other than infrastructure assets. This includes health, education, pensions and welfare, all of which tend to be inflationary (there are productivity gains in health and education but they are low and long-term). Obviously a government has to provide some sort of social infrastructure, and cannot (and should not) avoid spending on these things. However, the massive increase in government spending over the past 9 years, with no productivity gain, is the current main driver of our inflation rate.

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  28. dog_eat_dog (677 comments) says:

    MacDoctor, your analysis is spot on, minus one thing: Kiwisaver. Kiwisaver is woefully inflationary – the only way it could not be inflationary is if banks reinvest every single contribution dollar the government gives them in productive capital. They don’t.

    Take a look at some of the finance company ads – one on TV now doing the rounds says ‘Live the way you want to’. New Zealanders are financially inept and finance companies prey on the weak and ignorant, with promises of instant satisfaction. It amazes me that a leftist government has let this market go largely unregulated with it’s predatory advertisements.

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  29. reid (15,530 comments) says:

    In terms of dealing with immediate inflation as an emergency measure, would this work?

    Remove immediately all fuel taxes across all fuel types: excise, RUC, whatever.

    Simultaneously commit to funding ALL existant and on-going transport programs from remaining govt revenue.

    At one stroke you’ve slashed both govt spending and a significant driver of the CPI.

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  30. Owen (5 comments) says:

    Dime wrote: “who controls the printing of money? which govt dept?

    how much do they print per year? do they explain why they are printing said amount?”

    The Reserve Bank.

    You can only control one of two things at once, the money supply or the price of money (interest rate). The RB sets the price of money (just like a Monopolist does) and then prints as much money as is demanded at that price.

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  31. Owen (5 comments) says:

    Paradigm wrote:”Respectfully, I must disagree: As I suggested earlier, increase in price from high demand will inevitably cause labour to demand higher wages. We can then describe the situation as follows: Workers are now paid more for the same production output AND it now costs more for to purchase the same goods, services. In short the value of money has decreased.”

    Respectfully, I must disagree. You cant disagree with the definition of inflation, thats simply what it is.

    The flaw in your logic is that you are taking a microeconomic concept and agregating it to take a view on the entire economy, it simply doesnt work that way. Most macroeconomics is junk for this very reason.

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  32. NZD.JPY (130 comments) says:

    I agree with Mac Doctor except where he agrees with Paradigm.
    Paradigm – “As I suggested earlier, increase in price from high demand will inevitably cause labour to demand higher wages….Workers are now paid more for the same production output AND it now costs more for to purchase the same goods, services. In short the value of money has decreased ”

    This is not inflation with reagrd to the value of the dollar, but only a rise in price for the good in question which is entirely different.
    Like Owen implied if there is greater demand for a good, there must be either a reallocation of preference toward it or some other external means of funding this new preference. The value of money hasn’t decreased in aggregate rather the price of this one good has increased. Paradigm is ignoring the other micro-markets that fall out of preference in order to fund an increase in demand for his rising good.
    None of this explains why in aggregate the dollar is worth more or less.

    I don’t like Brash’s idea. Why tamper with “legitimate” demand for a good or service because it is in the basket of goods used to measure inflation? (it’s in this basket for good reason though i.e oil has low elasticity of demand and is cruicial for our economic health but even so this basket is only a proxy for inflation). All this does is hide true inflation which I agree comes about entirely because of the amount of $ chasing the amount of goods. Inflation has only been good for Cullen.

    Also Paradigm, please back up your assertion that restricting the printing of money will be economic suicide. The answer to the current credit crunch is not to print more money so banks have more to lend. The answer is to properly identify risk and lend accordingly. Highly risky lending is not necessarily good lending just because it has a high yield when it doesn’t default.

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  33. NZD.JPY (130 comments) says:

    I use “Cullen” above as a label for governments who overspend in unproductive areas.

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  34. NZD.JPY (130 comments) says:

    Actually having re-read MacDoctors post I no longer agree. Government spending in unproductive areas is probably the main cause of our decline in productivity not inflation. If money supply hadn’t increased then there would have been an even sharper decrease in productivity due to a reallocation away from productive areas (via taxes) but this has been counteracted by an increase in money supply and sticky prices. I.e. when you print more money you actually are richer in the period it takes for the market to fairly reassign value to the dollars in circulation. (Dollars are only a token representing a share in the economy of issue). The government uses this grace period to fund their unproductive spending and get away with it at the expense of savers and the productive sector. Savers are then compensated by an increase in interest rates so the cost falls to the productive sector. That’s why unproductive voters vote for unproductive governments. They don’t carry the cost.

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  35. NZD.JPY (130 comments) says:

    I’ll shut up soon. The higher interest rates attract foreign demand for the NZD which increases its price from a demand side which is a deflationary pressure. This all subsidises the decrease in productivity and causes those on the receiving end (i.e. those who got wealthier without being productive) to wonder what all the fuss is about. Their house prices have climbed for no extra effort on their part which makes them feel richer and now that they’re used to this wealthy feeling they won’t sell their house for what they’re offered because that would mean they’re not rich after all. In fact they aren’t in real terms, only nominal. They still only own a house which people have done for eons.

    Answer – move to a more productive, frugal country where you can earn loads more and keep it and not subsidise academics who specialise in political science who accuse you of being miserly or greedy when in fact they are the ones who are better off at your expense.

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  36. paradigm (507 comments) says:

    My appologies NZD.JPY and others. My comment about restricting money supply was with reference to doing so strongly as to remove all inflation, rather than just control it. Attempting to remain at this position for any length of time would lead to a general underutilisation of resources available to the economy. This is presumably why central bankers choose to tollerate a degree of inflation – as it is needed for the efficient utilisation of resources.

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  37. NZD.JPY (130 comments) says:

    Absolutely no need to apologise paradigm.
    I still don’t understand why you think that zero inflation would lead to underutilisation of resources though. If money supply increases at the same rate as the economy expands then there would be no more or less utilisation than there is now? In other words the dollar would maintain its current value. You’d be better off because you had some productivity growth and older goods would be cheaper because of new replacements but no more or less purchasing power per dollar. If there were more dollars in circulation without corresponding productivity growth you’d be nominally better off because you had more dollars in the hand but in fact each dollar is worth less in purchasing power terms. In that sense I don’t know why central banks tolerate inflation. I can’t see the benefits. The sticky price effect is a bubble.

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  38. paradigm (507 comments) says:

    Perhaps the question becomes are we good enough at controlling the supply to keep it at exactly zero inflation, and what happens when it slips to either side of zero. We know what happens when it is slightly above zero, that is the normal situation in most countries. But if it drops below zero we should get falling prices and wages, however both are often somewhat downwardly immobile so instead of downward prices and wages we get downsized production and employment; the reduced employment leads to a drop in spending power, further reducing demand which is further responded to by more downsizing, forming a deflationary spiral. It is a matter of history that deflation has been more damaging than moderate inflation, so it is perhaps useful to tolaerate the latter as a buffer against the former.

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