How Inflation Expectations Influence Monetary Policy Effectiveness And Should Inflation Targeting

Topics: Inflation, Monetary policy, Central bank Pages: 9 (2789 words) Published: February 27, 2015
How Inflation expectations influence monetary policy effectiveness and should inflation targeting (IT) be adopted in China?

Introduction
After the 2008 financial crisis, to stimulate the economy and stabilize the prices, the Chinese central bank implemented a straightforward monetary policy. This policy consists of increasing money supply and lowering interest rates, which presented a risk of inflation. According to National Bureau of Statistic (NBS) data, there has been a 2.5% increase in Consumer Price Index (CPI) in January 2014, but 55.8% of the Chinese people think the inflation will sharply increase. The difference between real and expected inflation has prompted the central bank to consider how inflation expectation play a role in the process of monetary policy implementation and conduct.

Based on the history of monetary policy in USA, Orphanides and Williams(2004) have found that the change of public expected inflation will result in the failure of monetary policy. To manage uncertain predictions, many developed countries, such as Britain, have adopted inflation targeting (IT) regime instead of conventional one. IT regime means the central bank takes monetary tools forward to certain inflation level for economic stability (Mishkin, 2000). He claims that it is useful to decrease the inflation fluctuation and maintain outcomes by adopting IT, although there is no certain evidence to show its improvement in outcomes (Ball and Sheridan, 2004). To reduce influence of inflation expectations on price stability and economic growth, it is necessary and available to adopt inflation-targeting regime in China, despites imperfect institutional independence, financial system, economic structure and technical infrastructure.

This essay will begin with the discussion about interaction between inflation expectations and monetary policy effectiveness, followed by identifying the features of inflation expectations. The essay will then focus on what benefits inflation targeting regime produces and will argue that the inflation targeting is suitable for China now.

Interaction between inflation expectations and monetary policy Stabilizing price level and keeping economic growth are viewed as the ultimate objectives of monetary policy, which are also the standard for evaluating policy effectiveness. Orphanides and Williams(2004) states that inflation expectations can help to decrease the effectiveness of monetary policy due to behavior changes among economic agents, such as households and firms. The development tendency of economic variables lies in, to a large extent, what economics decisions they have made according to their expectations. Wage negotiation, price setting, investment and so on, are viewed as the main channels. Assumed that monetary policy is effective, an expansionary policy would contribute to increases in output, however it seems not to be the fact. With the increase of money supply and price level, economic agents tend to generate higher inflation expectations.

On the one hand, this may drive households to adjust their investment activities and pursue higher level of wages. When households consider that future real interest rates would be lower than inflation rates, to minimize losses, they are inclined to reduce savings but have an increase in consumption and investment, especially in real estate. At the same time, wages is fixed for a period of time; it is therefore necessary for workers to seek satisfied and higher nominal wages as an offset of upward price level based on their expectations. This is because if nominal wages remain unchanged, the real level of wages will be decreased under improved price level. By doing this, workers could maintain real purchasing power and avoid the risk of currency devaluation.

On the other hand, if firms predict that future inflation remains high, they will have to take steps in response to the rising cost of production coming from means of production, such...

References: Orphanides, A. and Williams, J. (2004). Imperfect knowledge, inflation expectations, and monetary policy. University of Chicago Press, pp.201--246.
Mishkin, F. (2000). Inflation targeting in emerging market countries. 1st ed. Cambridge, MA: National Bureau of Economic Research.
Ball, L. and Sheridan, N. (2004). Does inflation targeting matter?. University of Chicago Press, pp.249--282.
Muth, J. (1961). Rational expectations and the theory of price movements. Econometrica: Journal of the Econometric Society, pp.315--335.
Driver, R., and Windram, R. (2007). Public Attitudes to Inflation and Interest Rates. Bank of England Quarterly Bulletin.
Blanchflower, D. (2008). inflation, expectations and Monetary policy. Bank of England Quarterly Bulletin, p.2.
Batini, N. and Laxton, D. (2007). Under what conditions can inflation targeting be adopted? The experience of emerging markets. Central Banking, Analysis, and Economic Policies Book Series, 11, pp.467--506.
Girardin, E., Lunven, S. and Ma, G. (2014). Inflation and China’s monetary policy reaction function: 2002--2013. Frank Packer and Aaron Mehrotra, p.159.
Svensson, L. (1997). Inflation forecast targeting: Implementing and monitoring inflation targets. European Economic Review, 41(6), pp.1111--1146.
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