Inflation targeting is a problematic strategy, especially for a developing country like India, which already has high rates of open and disguised unemployment.
THERE are several myths about economics that have proved to be very hard to dislodge, despite theoretical proof and empirical evidence that directly contradict them. One such myth is that governments can control money supply. There is the related myth that this money supply that the government can control is then responsible for creating inflation, based on the simplistic notion that too much money chasing too few goods will cause prices to rise.
The reality is that as economies grow more sophisticated in terms of the spread of finance, it is always possible for new types of liquidity, or "quasi-money" to emerge, and so it is actually impossible for governments to control the actual money supply. This has become more relevant recently because financial innovation creates new possibilities for liquidity.
Thus, credit card transactions, bills of exchange, IOUs, hire purchase agreements, all involve the creation of liquidity. There have been situations in which share certificates have been treated as liquidity.
In financial markets, the emergence of futures trading and derivatives has created very complex webs of liquidity creation. In fact, there are new forms of liquidity emerging all the time - consider the frequent flyer miles created as incentives by airlines. With money taking so many complex forms, many of which are near impossible to regulate, it is not really useful to talk about regulating money supply.
This means that the level of money supply is determined by the workings of the system, by the level of economic activity and the prices at which goods and services are traded. So this is one clear case where demand creates supply. Therefore, there is a strong case for arguing that in a world of financial innovation where quasi-moneys can be created, the overall liquidity in the system cannot be rigidly controlled by the central bank.
Nor is there a convincing case for the argument that increasing money supply causes inflation, since there is no easily discernible relationship between the rates of growth of money supply and of inflation on the one hand, and real output growth on the other. This argument is based on the twin assumptions of full employment (or exogenously given aggregate supply conditions) and aggregate money supply determined exogenously by macro policy. But neither of these assumptions is valid.
Further, the notion of a stable "real demand for money" function (where the demand for money is determined by the level of real economic activity) is one which gets demolished by the possibility of speculative demand for money, a feature which, if anything, is enhanced by financial sophistication and the greater uncertainties of operating in today's economies.
Therefore, the real monetary variable in the hands of the government is the interest rate and thus attempts to control money supply typically end up as forms of interest rate policy instead.
There was a time when it was assumed that the basic goal of macroeconomic policies was achieving internal balance, defined as full employment, along with external balance, defined as balance on the external account.
If there was unemployment and excess capacity in the economy, the aim of fiscal and monetary policies would be to generate sufficient economic expansion to reach the full employment target; conversely, going beyond that target would generate inflation because of supply bottlenecks.
Openness obviously complicated the picture not only because of the effect of domestic expansion upon the current account of the balance of payments, but also because of the possible effect upon capital flows. In the Keynesian framework, achieving internal and external balance together required the use of not only the domestic levers of policy but also the exchange rate.
Monetary policy was seen as part of this overall strategy of aggregate demand management combined with exchange rate management, and in this strategy, inflation control was only one of its several simultaneous aims.
In fact, in developing countries, the aims of monetary policy related not only to the level of economic activity and employment, but also to more specific aims such as ensuring investment, including in particular areas, or even poverty reduction. Monetary policy was, therefore, seen as an integral part of macroeconomic and overall development strategies, and could not be reduced simply to the goal of inflation control.
However, in recent years, the focus of monetary policy in many countries across the world has changed, such that central banks are increasingly oriented to fixing a particular target for the inflation rate, and adjusting the interest rate and other banking policies accordingly.
This, in turn, means that all other objectives are ignored, while the monetary authority focuses upon somehow achieving the desired rate of inflation. The extreme case of this is found with "independent" central banks, which publicly declare a certain desired rate of inflation and then adjust monetary levers accordingly.
While this was first attempted in developing countries, a large number of developed countries have also adopted this practice, especially as it has been given a seal of approval by the multilateral financing institutions as well as organisations of international investors.
However, this strategy can be critiqued on a number of grounds. The most common critique relates to the economic costs in terms of high real interest rates which, in turn, inhibit economic expansion and employment generation, even in contexts of substantial unemployment and persistent poverty. The consequent inability of governments to address the problem of unemployment has proved to be not only economically wasteful but also politically painful for many governments.
In any case, it is completely unnecessary, since there is no convincing evidence to suggest that inflation actually has any effect upon real macro variables, and its impact upon income distribution depends upon institutional conditions in an economy.
There are other problems with this approach. Unlike the macroeconomic strategies described earlier, inflation targeting does not necessarily generate either internal or external balance, much less achieve both simultaneously. In fact, if fiscal policy is oriented towards exchange rate targeting (which is currently common in many emerging market economies) then there can be quite severe problems of coordination between the two.
Thus, a devaluation can have expansionary effects upon export production and import substituting production, but only if the central bank does not immediately hike interest rates in order to prevent the devaluation from having inflationary consequences in excess of its own target rate of inflation.
Conversely, focussing on low inflation targets may cause the government to become excessively contractionary in its own behaviour, thereby having implications for exchange rate management as well.
Therefore, inflation targeting is a very problematic strategy, especially for a developing country like India that already has high rates of open and disguised unemployment. It is disturbing to think that it could even be contemplated by our policymakers.
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