Celebrating humanity's flourishing through the spread of capitalism and the rule of law
23 Apr 2015 Leave a comment
in inflation targeting, macroeconomics, politics - Australia, politics - New Zealand Tags: Australia, CPI bias, inflation, New Zealand
In praise of measurement error: good thing no one noticed the severe deflation in Australia and in New Zealand in the late 1990s for otherwise the do-gooders might have felt the need to do something about it. Good thing no one is panicking over the recent mild deflation in New Zealand as well.
Source: OECD StatExtract
22 Apr 2015 Leave a comment
in econometerics, inflation targeting, macroeconomics, politics - USA Tags: CPI bias
All agree that the consumer price index (CPI) is biased and overstates inflation. In 1996, economists hired by the Senate Finance Committee estimated that the U.S. CPI overstates annual inflation by 1.1% (Boskin et al. 1996). That estimated CPI bias has not gotten smaller with time. It is now up to 1.5%, even 2%.
The main biases in the consumer price index everywhere come from how to handle changes in the quality of goods and services and how to deal with completely new goods and services.
I thought I might see what happened if I took account of this one and a half percentage point annual bias because of new goods, quality variation and other known biases in the CPI estimates for the USA, UK and Japan in the relevant OECD StatExtract database for annual CPI inflation.
Source: OECD StatExtract.
Taking into account new good and quality bias, Japan is been in serious deflation for quite some time now – at least 20 years. Japanese inflation went positive in the last year or two because I believe they increased their consumption tax.
The USA has a low inflation for about 20 years. The UK had no inflation for about seven years from 1997 then it started to rise again until 2012.
People get hot and bothered with deflation. Breathless journalism aside, fears of inflation are just a legacy of the great depression in the 1930s.
The only depression where deflation was accompanied by mass unemployment was the Great Depression. Mild deflation with good growth is a common phenomenon as Atkinson and Kehoe found:
Are deflation and depression empirically linked? No, concludes a broad historical study of inflation and real output growth rates. Deflation and depression do seem to have been linked during the 1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.
21 Apr 2015 Leave a comment
in global financial crisis (GFC), great depression, inflation targeting, macroeconomics, monetary economics Tags: CPI bias, deflation, inflation, monetary policy
All agree that the consumer price index (CPI) is biased and overstates inflation. In 1996, economists hired by the Senate Finance Committee estimated that the U.S. CPI overstates annual inflation by 1.1% (Boskin et al. 1996). That estimated CPI bias has not gotten smaller with time. It is now up to 1.5%, even 2%.
One of the rationales for the inflation target of the Reserve Bank of New Zealand of 0-2% was the 2% was to account for the consumer price index was biased upwards. Targeting 0% would lead to mild deflation when inflation was properly measured.
The main biases in the consumer price index everywhere come from how to handle changes in the quality of goods and services and how to deal with completely new goods and services.
I thought I might see what happened if I took this one and a half percentage point annual bias in the CPI estimated for the USA and adjusted the New Zealand CPI inflation rates available at the Reserve Bank of New Zealand’s website over the last 20 years or so with this number.
If these consumer price index bias adjustments are correct, and they are roughly correct, inflation came to a dead stop in New Zealand after the global financial crisis in 2008, spiked again, and then moved into deflation in 2012. If anything, there’s been a mixture of price stability and the deflation since 2012.
People get quite hot and bothered with deflation. The New Zealand economy has been in a deflationary phase since the beginning of 2012 but it is recently grown so quickly that it is referred to in the media as the rock-star economy.
Breathless journalism aside , fears of inflation are just a legacy of the great depression in the 1930s. The only depression where deflation was accompanied by mass unemployment was the Great Depression. Mild deflation with good growth is a common phenomena as Atkinson and Kehoe found:
Are deflation and depression empirically linked? No, concludes a broad historical study of inflation and real output growth rates.
Deflation and depression do seem to have been linked during the 1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.
31 Mar 2015 1 Comment
in business cycles, economics of information, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics Tags: lags on monetary policy, monetary policy
There are large uncertainties about the size and timing of responses to changes in monetary policy. There is a close and regular relationship between the quantity of money and nominal income and prices over the years. However, the same relation is much looser from month to month, quarter to quarter and even year to year. Monetary changes take time to affect the economy and this time delay is itself highly variable. The lags on monetary policy are three in all:
The lag between recognition and the taking of action (the legislation lag)
the lag between action and its effects (the implementation lag)
These delays mean that is it difficult to ascertain whether the effects of monetary policy changes in the recent past have finished taking effect.
Secondly, it is difficult to ascertain when proposed changes in monetary policy will take effect. Thirdly, feedbacks must be assessed. The magnitude of the monetary adjustment necessary to deal with the problem at hand is never obvious.
It is common for a central bank to act incrementally. The central bank makes small adjustments to monetary conditions over time as more information is available on the state of the economy and forecasts are updated.
Most discussions on monetary policy focus on the implementation lag. This lag depends on the fundamental characteristics of the economy.
A long and variable implementation lag means that it is difficult for central banks to ascertain what is happening now or forecast what will happen. Central banks may stimulate the economy after it is well on the way to recovery and tighten monetary policy when the economy is already going into a recession.
In his classic A Program for Monetary Stability, published in 1959, Milton Friedman summarised his empirical findings on length and variability of the lags on monetary policy:
on the average of 18 cycles, peaks in the rate of change in the stock of money tend to preceded peaks in general business by about 16 months and troughs in the rate of change in the stock of money to precede troughs in general business by about 12 months. For individual cycles, the recorded lead has varied between 6 and 29 months at peaks and between 4 and 22 months at troughs.
With lags as variable as those estimated by Friedman, it is difficult to see how any policy maker could know which direction to adjust his policy, much less the precise magnitude needed. Long lags greatly complicate good forecasting. A forecaster cannot know what the state of the economy will be when his policy takes effect.
Many Keynesians, Friedman notes, advocate “leaning against the wind.” By this they mean, in some sense, that the monetary (and fiscal) authorities should try to balance out the private sector’s excesses rather than passively hope that it adjusts on its own.
Friedman tested the Fed’s success at leaning “against the wind” by checking whether the rate of money growth has truly been lower during expansions and higher during contractions. He admits that this method of grading he Fed’s performance is open to criticism, but decides to go ahead and see what turns up. He finds that Fed has – for the periods surveyed – been unsuccessful.
By this criterion, for eight peacetime reference cycles from March 1919 to April 1958. Actual policy was in the ‘right’ direction in 155 months, in the ‘wrong’ direction in 226 months; so actual policy was ‘better’ than the [constant 4% rate of money growth] rule in 41% of the months.
Nor is the objection that the inter-war period biased his study is good since Friedman found that:
For the period after World War II alone, the results were only slightly more favourable to actual policy according to this criterion: policy was in the ‘right’ direction in 71 months, in the ‘wrong’ direct in 79 months, so actual policy was better than the rule in 47% of the months. [2]
One of the best ways to parry a metaphor is with another metaphor. Keynesians have a host of metaphors in their rhetorical arsenal; one frequently voiced is that a wise government should “lean against the wind” when choosing policy. Friedman counters:
We seldom know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two from now. Leaning today against next year’s wind is hardly an easy task in the present state of meteorology.
By scrutinising the practice of monetary policy over the decades, Friedman manages to produce objections that both Keynesians and non-Keynesians must take seriously. A key part of any response to Friedman rests on the ability of forecasters to do their jobs with tolerable accuracy.
25 Mar 2015 1 Comment
in business cycles, economic growth, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics, Robert E. Lucas Tags: Keynesian macroeconomics, monetary policy
The competing visions of central banks over monetary policy have been defined by Franco Modiglani and Milton Friedman respectively. Modiglani considers the Keynesian vision of macroeconomic policy to be:
a market economy is subject to fluctuations which need to be corrected, can be corrected, and therefore should be corrected.
The Keynesian claim implies that central banks have sufficient knowledge of the structure of the economy to be able to choose the policy mix appropriate to a given set of circumstances. It is possible to target unemployment, interest rates and inflation in such a way that they can be maintained (and hence made predictable) by constant adjustment of policy instruments to new shocks.
The Keynesian approach assumes that the economy can slip into recessions for all sorts of reasons (Barro 1989). Business fluctuations result from shocks to aggregate demand. The principal source of these shocks are expectations induced shifts in investment demand. The role of the central bank is to make prompt, frequent policy responses to counteract this instability.
The task of government is to discover the particular monetary and fiscal polices which can eliminate shocks emanating from the private sector. A key finding of recent macroeconomic research is that anticipated monetary policy has very different effects to unanticipated monetary policy.
The Keynesian vision thus presuppose that government can foresee shocks which are invisible to the private sector but at the same time it is unable to reveal this advance information in a credible way and hence defusing the shock because it is no longer unanticipated. In addition, the counter cyclical monetary policies of governments must themselves be unforeseeable by private agents, but at the same time systematically related to the state of the economy (Lucas and Sargent 1979)
Of course, the Keynesian view of central banking is also premised on a goodwill theory of government. Governments pursue policies that are in the public interest. That is a public interest that is well-defined and is free of conflicts over income distribution, electoral success and power the could lead policy-makers to pursue goals other than full employment, stable prices and efficiency. Thus, if the latest forecast is a recession, additional stimulus is the usual prescription. However, since most Keynesian economists accept the permanent income and natural rate hypotheses, more stimulus implies less later at some unknown time.
Friedman’s vision of central banking is far more circumspect:
The central problem is not designing a highly sensitive [monetary] instrument that offsets instability introduced by other factors[in the economy], but preventing monetary arrangements becoming a primary source of instability (Milton Friedman 1959).
Friedman considers that a key element in the case for policy discretion is whether the sufficient information is available that can be used to reduce variability and assist the economy’s adjustment the unforeseen. A well intentioned policy-maker will destabilise if he is mislead by incomplete or incorrect information.
From the monetarist standpoint, price stability can be approximately attained under a well chosen and predictable monetary policy rule. Under this view, the unemployment and interest rates are unpredictable and can manipulated only at a prohibitive cost. The Keynesian and monetarist views are mutually incompatible and lead to very different policy recommendations (Lucas 1981).
20 Mar 2015 Leave a comment
in economic history, inflation targeting, macroeconomics, monetary economics, politics - New Zealand
After the high inflation rates in the 70s and 80s, inflation disappeared by the end of the century. There is the occasional spike in the 2000s but now inflation is effectively zero. Measurement error in the consumer price index for increases in product quality and new goods means an inflation rate of about 2% rounds down the inflation rate to zero.
Source: Reserve Bank of New Zealand.
19 Mar 2015 Leave a comment
in budget deficits, business cycles, economic growth, fiscal policy, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics Tags: fiscal policy, monetary policy, Paul Samuelson, rules versus discretion, stabilisation policy
via Samuelson vs. Friedman, David Henderson | EconLog | Library of Economics and Liberty and An Interview With Paul Samuelson, Part One — The Atlantic.
15 Mar 2015 Leave a comment
in currency unions, Euro crisis, inflation targeting, macroeconomics
When members of a monetary union are experiencing different macroeconomic conditions, a single policy rate is unlikely to fit circumstances in all countries. Currently, the ECB’s target rate seems to be in line with a Taylor rule recommendation for the euro area as a whole. However, economic differences between peripheral and core euro-area countries are sharp. The core countries are recovering, while the peripheral countries still have large unemployment gaps. Thus, the ECB target rate is not in line with Taylor rule recommendations for the peripheral countries.
via Federal Reserve Bank San Francisco | Monetary Policy When One Size Does Not Fit All.
02 Feb 2015 Leave a comment
in business cycles, fiscal policy, inflation targeting, macroeconomics, monetary economics Tags: new classical macroeconomics, Paul Samuelson, policy credibility, rational expectations, regime uncertainty, Stephen Williamson, time inconsistency, Tom Sargent
30 Jan 2015 1 Comment
in business cycles, econometerics, economics of bureaucracy, economics of information, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics, politics - Australia, politics - New Zealand, politics - USA Tags: lags on monetary policy, Levis Kochin, monetary policy
Monetarists blame fluctuations in inflation on excessively volatile growth in monetary aggregates. In 1982, Friedman defined monetarism in an essay on defining monetarism as follows:
Like many other monetarists, I have concluded that the most important thing is to keep monetary policy from doing harm.
We believe that a steady rate of monetary growth would promote economic stability and that a moderate rate of monetary growth would prevent inflation
The U.S. data supported this hypothesis about the volatility of monetary growth and inflationuntil 1982, but since 1983 monetary aggregates have been essentially uncorrelated with subsequent inflation in the U.S.
Levis Kochin pointed out in 1979 that a well designed monetary policy would lead to zero correlation between any measure of monetary policy and subsequent inflation. The reason for this is the correlation between any variable and a constant is zero.
If monetary growth is stable, say, a constant growth rate of 4% per year, as advocated by Milton Friedman, monetary growth will have no correlations with any variable:
Poole (1993, 1994) and Tanner (1993) also argue that one predictable consequence of optimal monetary policy is that the correlation between monetary policy instruments and policy goals will be driven to zero.
Poole further contends that it is obvious to any careful reader of Theil (1964) that optimally variable policy will give rise to a zero correlation between policy and goal variable…
In 1966 Alan Walters, a U.K. monetarist, observed:
If the [monetary] authority was perfectly successful then we should observe variations in the rate of change of the stock of money but not variations in the rate of change of income… [a]ssuming that the authority’s objective is to stabilize the growth of income.
Milton Friedman in 2003, wrote about how the Fed acquired a good thermostat:
The contrast between the periods before and after the middle of the 1980s is remarkable.
Before, it is like a chart of the temperature in a room without a thermostat in a location with very variable climate; after, it is like the temperature in the same room but with a reasonably good though not perfect thermostat, and one that is set to a gradually declining temperature.
Sometime around 1985, the Fed appears to have acquired the thermostat that it had been seeking the whole of its life…
Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability as Chart 1 illustrates.
Yet since the mid ’80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity.
Nick Rowe explained the difficulty of causation and correlation under different policy regimes and Milton Friedman’s thermostat superbly as an econometric problem Nick Rowe:
If a house has a good thermostat, we should observe a strong negative correlation between the amount of oil burned in the furnace (M), and the outside temperature (V).
But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P). And we should observe no correlation between the outside temperature (V) and the inside temperature (P).
An econometrician, observing the data, concludes that the amount of oil burned had no effect on the inside temperature. Neither did the outside temperature. The only effect of burning oil seemed to be that it reduced the outside temperature. An increase in M will cause a decline in V, and have no effect on P.
A second econometrician, observing the same data, concludes that causality runs in the opposite direction. The only effect of an increase in outside temperature is to reduce the amount of oil burned. An increase in V will cause a decline in M, and have no effect on P.
But both agree that M and V are irrelevant for P. They switch off the furnace, and stop wasting their money on oil.
Subsequent work of Levis Kochin showed that if the effects of fluctuations in monetary aggregates were not precisely known then the optimal policy would produce negative correlations between monetary aggregates and inflation:
The negative correlation results from coefficient uncertainty because the less certain we are about the size of a multiplier, the more cautious we should be in the application of the associated policy instrument.
Therefore, although optimal policy leads to lack of correlation between the goal and control variables if the coefficient is known, it will lead to a negative relationship if there is coefficient uncertainty. The higher the uncertainty, the more cautious will be the optimal policy response. Also, if the control variable can’t be controlled perfectly then the correlation between the goal and the control variable becomes positive i.e., the control errors are random…
Uncertainty about the impact of a policy will stay the hand of any bureaucrat , much less a central banker, as Kochin and his co-author explain:
Uncertainty should lead to less policy action by the policymakers. The less policymakers are informed about the relevant parameters, the less activist the policy should be. With poor information about the effects of policy, very active policy runs a higher danger of introducing unnecessary fluctuations in the economy.
24 Jan 2015 Leave a comment
in applied welfare economics, business cycles, comparative institutional analysis, development economics, economic growth, global financial crisis (GFC), great recession, growth disasters, growth miracles, inflation targeting, macroeconomics, monetarism, Robert E. Lucas Tags: Robert E. Lucas
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