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Anonymous asked in Social ScienceEconomics · 1 decade ago

Does the goal of zero inflation require the rate of money growth to be zero as well?

1 Answer

  • 1 decade ago
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    In very simple terms: A zero inflation rate would require that the growth rate of the money supply is approximately equal to the growth rate of the economy, i.e. the GDP. With a higher growth rate, the economy will end in inflation, with a lower growth rate it will end in deflation. However, the target inflation rate is slightly higher than zero percent in order to give the central banks more freedom of action in their monetary policy decisions. Typically, a stable inflation rate of approximately 2% is considered as ideal.

    There is however, a better way of looking at this issue: In macroeconomics the rule that describes the behavior of the Fed (or any central bank) is known as the Taylor Rule. It says that the Fed should “lean against” both the business cycle and deviations from a target inflation rate of approximately 2%, raising interest rates when actual GDP exceeds potential GDP or inflation exceeds the target, and cutting interest rates when the opposite is true.

    The simple version of the Taylor Rule:

    Target interest rate = 2 + 1.5 * inflation rate - 2 * excess unemployment

    As an example, in the current US economy, the inflation rate is currently 1.6% (core PCE deflator), excess unemployment: difference between actual unemployment of 9.8% and the 'natural' or structurtal unemployment of 4.8%, would yield a target interest rate of

    2 + 1.5 * 1.6 - 2 * (9.8 - 4.8) = -5.6%.

    Unfortunately, negative interest rates are by definition impossible. This is the reason why in the current economic crises the monetray policy no longer works and the government has to use fiscal policies to pull the economy out of the crises.

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