Macroeconomics: Dispersion of Inflation Rates - Essay Example

Macroeconomics: Dispersion of inflation rates In macroeconomics, inflation is one of the main and most complicated issues. The widespread issue of the inflation and of its acceleration, and especially the reduction in its dispersion, has led to a rather general acceptance of the view that it is being transmitted among countries to a greater extent than before, to expositions of various possible mechanisms of transmission, and to econometric testing of the relative importance of these mechanisms. The aim of the paper is to discuss the process of international transmission itself and examines the interrelations between dispersion of national inflation rates and transmission. According to Wickens (2998) the greater prevalence of increases in national price levels and a convergence of their rates of increase suggest that international transmission has increased. The inference is not necessarily correct: other explanations are equally logical and sufficiently important to be worth serious consideration. Many countries might experience inflation at the same time without international transmission of inflationary forces because they respond in the same way to common causes (Wickens 54). All countries have undergone long-period institutional and structural changes which, although not in themselves inflationary, have made them more vulnerable to inflation. One of these changes is a widespread increase in the resistance to reductions of nominal prices and wages. Another is the growing role of the public sector in most national economies, a development that may increase the vulnerability to inflation in a number of different ways, which are discussed in the appendix to this paper. Another possible cause of a decrease in the dispersion of rates of change in consumer prices and other comprehensive price indexes, such as gross national product deflators, is a convergence in the rates of productivity growth of different countries. These comprehensive price indexes tend to diverge from the corresponding national indexes of wholesale prices in degrees related to the growth in a country's productivity. If changes in national wholesale prices continue to be tied together, a convergence of national rates of productivity growth would cause a convergence of changes in their consumer price indexes and GNP deflators (Wickens 51). Gali (2008) underlines that monetary changes may directly release inflationary forces. In the monetary field, the development and expansion of the Eurocurrency market, even if it has not greatly increased the supply of what one chooses to call "money," has increased the supply of liquidity or reduced the demand for it. Similarly, the establishment of special drawing rights has provided a non-national addition to the international reserve assets of the recipient countries without increasing the liabilities of other countries. Other explanations of a decrease in dispersion of inflation rates are also possible. For example, inflation rates may have been generated in many countries at the same time merely because cyclical expansion in a number of important countries coincided to an unusual degree (Gali 77). Although the probability that such similarity of movement in several large countries occurred by sheer coincidence may not be high, it is not so low as to be negligible; such synchronization has occurred at times in the past when the world economy is widely regarded as having been less integrated than it is now, and it occurred then to a greater extent than in some subsequent periods, as is indicated by the evidence cited in the appendix (Gali 72). As national inflation rates may converge without increased international transmission through market forces, so may such transmission increase without making inflation rates converge. Indeed, an increase in such transmission may even increase the dispersion of some measures of inflation. This may be more than a possibility with regard to dispersion of consumer price indexes (Mishkin 82). It is now widely recognized that the more rapidly a country's productivity in producing tradable output grows, the greater tends to be the excess of the rise in its consumer prices over the rise in its wholesale prices. If consumer prices in countries with differing rates of productivity growth happened to be changing at similar rates when the world economy was not very highly integrated, their wholesale price indexes would be changing at different rates. If the world economy then became more integrated so that influences on prices were more completely transmitted from one country to another, the tightening of the linkage would reduce the dispersion of changes of wholesale prices, but the relationship between consumer prices and wholesale prices within each country would generally not be much changed, so that the dispersion of changes in consumer prices would increase. Thus the increase in transmission would increase rather than reduce the dispersion of changes in consumer price indexes (Gali 107). It is also possible, although less probable that increased transmission would not reduce dispersion of changes in GNP deflators. GNP deflators do not directly include changes in import prices, because they measure the average amount of value added per unit of national output. If, when import prices rise, the absolute margins added by domestic sellers of imported goods remain unchanged or nearly so, and if there is little rise in prices of importcompeting output, there is little relationship between changes in average import prices and a properly calculated GNP deflator (Mishkin 84). Despite all the foregoing cautionary observations about the relation between dispersion of changes in national price indexes and international transmission of inflationary pressures through market forces, the extension of inflation in recent years to virtually every country strongly suggests that international transmission, whether greater than in earlier years or not, has played a large role. Various possible mechanisms of transmission are examined below (Mishkin 98). The mechanisms contributing to the international transmission of inflation have their basis in the economic integration of the world economy (Mishkin 123). In specifying economic integration, I use the word mainly in a narrow sense of markets and market responses, which excludes similarities in the policy responses of governments and large groups in the private sector caused by the spreading of common knowledge, opinions, technology, and decisions following upon increased international communication and travel. Integration in the narrower sense of markets and market responses results from the international mobility (with or without actual movement) of goods and services, of labor, and of capital. Such mobility limits the degree to which prices, wages, and interest rates can differ in different countries. It also limits the degree to which their changes may diverge, an effect that is more relevant to the transmission of inflation. It is often said that the world economy has become more integrated as a result of reductions in the barriers to international movement of goods, labor, and capital (Mishkin 89). One of the influences affecting not only the degree but the direction in which prices of nontradable output are influenced is monetary policy. If it is sufficiently restraining, it may force compensating decreases in prices of nontradable goods. The fact that monetary influences are also a channel for international transmission indicates that the various mechanisms of international transmission are interrelated and that the mechanisms conventionally described as channels of international transmission depend for their operation on assumptions about domestic monetary conditions and about other elements of intranational transmission that are rarely mentioned. Increases in world prices of a country's exports also generally have pervasive price-raising effects (Wicken 65). If they are caused by factors outside the country under consideration, they lead to an increase in the money demand for its exports, whether they result from an increase in foreign demand for the total world supply of such goods or from decreases in the supply functions of foreign competitors (Wickens 84). The GNP deflator is directly affected by these increases in price. To the extent that the exports consist of consumer goods the domestic and export prices of which move together, or to the extent that domestically consumed goods are close substitutes for the exports or use them as direct or indirect inputs, export price increases also affect the consumer price index. If the exports that rise in price are neither consumer goods nor inputs into them, they do not affect that index directly, but several possible intranational linkages with other variables can cause them to affect other domestic prices (Wickens 82). This second mechanism is the tendency for any increase in the nominal goods-and-services balance to generate an increase in aggregate money demand for domestic output. Through this primary increase, further increases in income and demand are generated by means of the familiar multiplier effect (Bernanke et al 17). If this tendency is not suppressed by policy measures, it becomes an actuality. In an inflationary external environment such an increase in the balance of goods and services is generally the result of an increase in foreign demand for the total world output of the given country's exports, but, as noted above, it may also be the effect of a decrease in supplies offered at given prices by foreign competitors. Increases in the demand for a country's exports raise its domestic nominal income and aggregate demand, whether they increase the quantity of exports, export prices, or both. If the demand increases raise export prices but not real domestic output, the improvement in the terms of trade permits an increase in total real expenditure by domestic residents. Similarly, a rise in the balance on goods and services as the result of an externally caused reduction of imports can bring about inflationary pressure by diverting domestic demand from foreign to domestic output. Such a diversion will occur when prices of imports rise and the demand for them is more elastic than unity (Bernanke et al 15). Gali underlines that when import prices rise and the price elasticity of demand for them is less than unity so that the value of imports rises, the two mechanisms operate in conflicting ways. The rise of import prices themselves and of prices of goods that are produced from them or are substitutes for them is inflationary, but the decrease in the net balance of goods and services, to the extent that it is not offset by a decrease in the saving function, reduces aggregate demand and is in that respect deflationary (Gali 32). Whether a rise in import prices that has such effects should be regarded as "inflationary" or "deflationary" is in part a semantic question that arises because the term "inflationary" is used to mean both "tending to raise prices" and "tending to create or increase excess aggregate demand." Inasmuch as excess demand can be reduced by a rise in prices caused otherwise than by excess of demand, a rise in prices can be inflationary in the first sense and deflationary or anti-inflationary in the second (Gali 38). In sum, the net effect on the direction of movement of the general price level will be, since the direction of its effect depends both on the relative sizes of various coefficients of behavior in the mechanism determining prices and on whether the effects being considered are those on the average price of gross national product, which includes exports but not imports, or that of gross national expenditure, which includes imports but not exports. Inflationary influences abroad that are most likely to give rise to such inflows are income expansion and easing of monetary policies in foreign countries, both of which would tend to cause a surplus in the total balance of payments of the country being considered, with the probability that foreign income expansion would work through effects on the current account and that foreign monetary expansion would affect both the current and capital accounts. Works Cited 1. Bernanke, B.S., Laubach, Th., Mishkin, F.S. Inflation Targeting: Lessons from the International Experience. Princeton University Press, 2001. 2. Gali, J. Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton University Press, 2008. 3. Mishkin, F. Monetary Policy Strategy. The MIT Press, 2007. 4. Wickens, M. Macroeconomic Theory: A Dynamic General Equilibrium Approach. Princeton University Press, 2008. Read More