Inflation Targeting, Seigniorage, and Economic Schools of Thought

Posted on Feb 16, 2025 in Economy

Main Features of Inflation Targeting

The main features of the monetary policy strategy of inflation targeting are:

  • A quantitative inflation target (generally 2%).
  • Using an internally-made conditional inflation forecast as an intermediate target variable.
  • A high degree of transparency and accountability.

Understanding Seigniorage

Seigniorage is the profit made by a government from issuing currency. It can be useful for the government as a source of revenue for:

  • Financing debt.
  • Funding expenditures.
  • Reducing deficits.

Inflation’s Impact on Government Debt

As inflation rises in advanced economies, it may affect government revenues and expenditures. Expenditure may be higher than revenues, causing a primary deficit. Rising inflation often leads to increased nominal interest rates, potentially resulting in a higher effective interest rate. This means the government faces higher costs on its outstanding debt. Consequently, if the primary deficit and interest rates increase, the government may need to borrow more to finance its operations.

Evolution of Economic Thought

Neoclassical Economics

Neoclassical economists believed that the market economy is a self-regulating institution, always tending to equilibrium and full employment without government intervention.

Keynesian Economics

John Maynard Keynes challenged neoclassical thought in several ways (The General Theory of Employment, Interest and Money, 1936). The Great Depression demonstrated that market economies were not self-correcting. Keynesian economics dominated from the 1940s to the late 1960s (“Golden decades”), characterized by full employment and the building of the welfare state. However, high public spending and loose monetary policy led to growing inflationary pressures.

Monetarism

Milton Friedman introduced “Monetarism,” with these basic principles:

  • Inflation is a monetary phenomenon (discussion on current inflation).
  • There is a “natural unemployment rate” that cannot be reduced in the long run.
  • Monetary policy must aim at keeping inflation under control.

Rational Expectations

Robert Lucas introduced the concept of “rational expectations” concerning the Keynesian trade-off between unemployment and inflation. This concept led to the idea of the “super neutrality of money”: Rational agents anticipate future inflation rates and adjust wages and prices accordingly (Price equation in the AD/AS model). Therefore, prices can fluctuate without significantly impacting employment levels.

Historical Monetary Regimes

The Gold Standard

The gold standard imposed strict discipline on central banks. Currency values were fixed in terms of a gold parity, maintaining gold parity. This imposed a hard discipline on governments and central banks, with no restrictions on international capital flows. Prices were generally stable, with some instances of deflation.

Interwar Regime

A series of short-lived exchange rate agreements characterized the interwar period: floating exchange rates (1919-25), hyperinflation in central Europe (Germany, Austria), and moderate inflation in the rest of Europe. A return to pre-war gold parities (circa 1925) occurred, but at unsustainable levels.

Bretton Woods System

Return to a system of fixed exchange rates. Stabilizing the domestic economy was a primary objective of monetary policy. Controls on international capital flows, but progressive opening of the trade account in Western economies. Key concepts: Balance of payments, Current account, Capital account, Financial account.

Monetary Policy After the Financial Crisis

Monetary policy in the aftermath of the crisis included:

  • Interest rate cuts.
  • Expansion of central bank balance sheets.
  • Large-scale asset purchases.
  • Forward guidance policies.

The Policy Trilemma

The Trilemma refers to the interconnected effects of:

  • Financial integration on monetary (mainly interest rates) independence and exchange rate stability.
  • Capital (in/out) flows.
  • Monetary independence on exchange rate stability and financial integration.
  • An increase in interest rates.
  • Exchange rate stability on the other two variables.
  • Intervention in capital markets.