Ask: Some economists have argued that the FED must increase its inflation goal from 2 percent to 3 or even 4 percent. Why would the effect of a higher inflation objective on the amount of real money balances in the long term be greater than in the short term?
Solution:
Economists often deal with price theory and monetary theory as conceptually different. Milton Friedman, for example, called this the most important division in the economy. Monetary theory, he argued, concerns the total price level and fluctuations in output and employment; Pray theory, on the other hand, explains how relative prices award scarce resources.
In my opinion, the border between the two is not as sharp as Friedman suggested; Price theory and monetary theory often cross in fascinating ways. A higher inflation goal can, for example, distort the comparative benefit by changing the relative prices. It can also discourage capital accumulation if the income tax of capital is not indexed for inflation. Both effects reduce the output and in turn lower the demand for real money balance.
These examples are worth mentioning, but it is not entirely the effects I had in mind when I asked the question. I rather thought of how a higher inflation objective would influence the decisions of households to adopt certain financial technologies. To this end, we let the income effects of higher inflation put aside and concentrate on this choice instead.
Households have access to a wide range of financial technologies for saving – such as checks and savings accounts, certificates of deposits, money market accounts and investment funds for money market, to name just a few. Some of these products, such as investment funds for money market, are almost as liquid as a payment account, but offer a considerably higher return. However, by making use of those higher returns, households require fixed costs – either in time, effort or attention – to open and manage the account.
The return offered by these accounts usually rise with inflation. When inflation expectations increase, the lenders require higher nominal interest rates to maintain the real value of their savings. Without such an adjustment, they would be repaid in dollars that are worth less than they spring, reducing their real returns.
When inflation is relatively low, these accounts offer little benefit compared to the traditional ChEC King or savings accounts. As a result, many households can discover that the fixed costs of opening and managing it are not worthwhile to get up. Although inflation can temporarily deviate from expectations, it is unlikely that households will take on new financial technologies, unless there is a long -term shift in the long -term trend.
In short, the inflation expectations of households are their decisions about whether or not to accept certain financial technologies. As a result, their response to a temporary deviation from inflation will differ from their response to a permanent increase in trend inflation.
If the trend rate rises – as it would do if the FED adopts a higher inflation objective – it can be worthwhile for households to make the fixed costs for opening and managing an investment fund of the Geldmarkt. As soon as they do that, we can no longer assume that the request from the household for real money balances remains constant.
We can illustrate this idea with a simple diagram that shows the relationship between the demand for real money balance and the nominal interest rate, I. The curve is labeled in the figure below D1 represents aggregated money question under the current inflation goal. When inflation is temporarily different from this target, households continue D11 to point Breducing their real balances to QSR In response to the higher nominal interest rate.
However, if the Fed permanently increases its inflation objective and responding households by adopting new financial technologies, the demand curve shifts to left to left D2. This new curve reflects a lower amount of real money balance that is requested at every nominal interest rate. As earlier, temporary fluctuations in inflation lead to movement D2. But if the inflation of the trend shifts again, the entire question curve shifts again.
The long -term aggregated money question curve, labeled DLRbonds D1 And D2. It reflects the complete adjustment of households to permanently higher inflation, including the approval of financial technologies that help them cut back on money. The relatively flatter slope of DLR The idea records that the demand for money in the long term is more sensitive to the nominal interest rate than in the short term.
Households will probably not immediately identify and accept new financial technologies. If the Fed increases its inflation objective, households will start to reduce their real money balance, but the full adjustment to the higher trend rate will take time. For this reason, the effect of a higher inflation objective on the amount of real balances in the long term is greater than in the short term.