Inflation Targets: Cutsinger’s solution – Econlib

Question: A number of economists are suggesting that the Federal Reserve should consider increasing its inflation target from the traditional 2 percent to a range of 3 or even 4 percent. What could explain why the impact of such an elevated inflation target on the demand for real money balances might be more pronounced in the long run compared to the short run?

Solution:

In the realm of economics, there exists a common perception that price theory and monetary theory occupy separate domains. Milton Friedman famously highlighted this distinction, positing that monetary theory pertains to the overall price level along with fluctuations in output and employment, while price theory focuses on how relative prices distribute scarce resources.

However, I contend that the lines separating these two theories are blurrier than Friedman implied; they often intertwine in intriguing ways. A higher inflation target, for instance, can disrupt comparative advantages by altering relative prices and might deter capital accumulation if capital income taxes remain unadjusted for inflation. Both consequences can suppress output, ultimately diminishing the demand for real money balances.

While these observations are noteworthy, they aren’t precisely the effects I wish to emphasize in this discussion. Instead, my focus is on how an elevated inflation target could affect households’ choices regarding specific financial technologies. Let’s set aside the income effects of higher inflation and concentrate on this decision-making process.

Households today have access to a variety of saving instruments, including checking and savings accounts, certificates of deposit, money market accounts, and money market mutual funds, among others. Some of these options, like money market mutual funds, offer liquidity comparable to checking accounts while delivering substantially higher returns. Yet, enjoying these benefits typically requires households to invest a fixed cost—be it time, effort, or attention—to open and manage such accounts.

The returns from these accounts generally increase with rising inflation. When inflation expectations ascend, lenders demand higher nominal interest rates to protect the real value of their savings. If they do not adjust their expectations, they risk being repaid in devalued dollars, which diminishes their actual returns.

In periods of low inflation, the advantages of these accounts over standard checking or savings accounts are minimal. Consequently, many households may conclude that the fixed costs associated with setting up and managing these accounts are unjustifiable. While inflation may occasionally deviate from expectations, households are unlikely to embrace new financial technologies unless there’s a sustained change in the long-term inflation trend.

To summarize, households’ expectations regarding inflation significantly influence their decisions about adopting certain financial technologies. Therefore, their reactions to temporary inflation fluctuations will differ from their responses to a lasting increase in the inflation trend.

When the trend inflation rate rises—as would occur if the Fed adopts a higher inflation target—it may become beneficial for households to incur the fixed costs associated with opening and managing a money market mutual fund. Once this transition occurs, we can no longer presume that households’ demand for real money balances remains static.

This concept can be illustrated with a basic diagram depicting the relationship between the demand for real money balances and the nominal interest rate, i. In the accompanying figure, the curve labeled D₁ signifies the aggregate money demand under the current inflation target. When inflation temporarily deviates from this target, households shift along the D₁ curve to point B, leading to a reduction in their real balances to Q_SR as a reaction to the higher nominal interest rate.

Conversely, if the Fed were to raise its inflation target permanently, and households respond by adopting new financial technologies, the demand curve shifts leftward to D₂. This new curve indicates a lower demand for real money balances at every nominal interest rate. Just as before, temporary inflation fluctuations will result in movements along D₂. However, should the trend inflation rate change again, the entire demand curve will shift once more. 

The long-run aggregate money demand curve, denoted as D_LR, connects D₁ and D₂. It reflects the complete adjustment of households to a permanently higher inflation rate, including the adoption of financial technologies that enable them to minimize money holdings. The relatively flatter slope of D_LR illustrates that, in the long run, money demand is more responsive to nominal interest rates than it is in the short run.

It is essential to note that households are unlikely to immediately identify and adopt new financial technologies. If the Fed increases its inflation target, households will start to reduce their real money balances, but the full adjustment to the new higher trend rate will take time. This gradual response explains why the impact of a higher inflation target on the quantity of real balances demanded is greater in the long run than in the short run.