Inflation is defined as a general and persistent tendency for prices to increase. This definition does not mean all prices are rising. Rather some products may experience stable prices while others even experience falling prices.
This definition implies that on average, prices are increasing over a time period. The persistent increase in prices means that money loses its value. For instance, a lot more money would be required to purchase the same amount of goods which one would have purchased some five years ago.
One major macroeconomic objective of governments all over the world is to keep prices stable or at the barest minimum. A low inflation rate has been considered by several people as the core objective. The issue, however, remains: who defines what the low rate of inflation is? Atkinson and Miller (1998), however, state that inflation rate below three per cent per annum is generally acceptable.
Inflation appears to be a worldwide phenomenon. Generally if the rate of inflation is below five per cent over a period of time, it is referred to as “Creeping inflation”. When inflation rises to very high rates it is referred to as hyperinflation.
The result of hyperinflation is that confidence in money is eroded and people find it uneasy using it as a means of exchange. Various writers agree on the adverse effects that high inflation has on economic performance. Alesina Summers (1993) for instance pointed out that high inflation rate may result in distortions of the economy, encourage rent seeking activity, or raise risk premium.
Romer and Romer (1989) in an empirical study of the United States economy suggested that in most cases U.S recessions occur because of the Federal Reserve suddenly controlling inflation after it has been neglected to spiral out of control. It is therefore expected that maintaining a consistently inflation averse policy would lead to less variable economic performance.
Inflation does not confer any general social benefit; rather, it unfairly redistributes wealth at the expense of the fixed income groups. A typical example of this group is people on salaries. In the Ghanaian situation these include teachers, civil servants, public servants, private sector employees, among others. Particular sufferers have been identified as those who depend on fixed money contracts. These contracts were made prior to the inflationary rise in prices.
Government road contractors in Ghana therefore bear the burden of rise in prices particularly so because payments are made years after the project has been executed. Inflation also distorts the keystone of the economy. In periods of inflation, price changes, as well as the speed of the change, vary and therefore businesses are unable to separate the permanent from the transitional and measure accurately consumer demand or operational cost.
Inflation therefore does not help free the market to sanction inefficient firms, nor does it reward efficient firms. Further, inflation reduces the quality of goods and services to consumers.
This can be attributed to the fact that consumers are less likely to oppose price increase when it takes the form of lowering the quality level. Inflation also has a negative effect on the quality of work as consistent rise in prices makes people suddenly believe, albeit erroneously, that it is possible to “get rich quick” and therefore scorn sober effort.
Inflation is also said to encourage debt and sanction thrift as any amount of money loaned, though will be repaid, the purchasing power will be reduced compared to when it was originally received. People are therefore motivated to borrow and repay later as opposed to save and lend. In sum, inflation reduces the general standard of living rather than creating prosperity.
Is inflation therefore always a bane? The Phillips curve (PC) explains that there is a negative relationship between the unemployment rate and the inflation rate. High rates of growth in aggregate demand stimulate output and thus reduce the unemployment rate. These high rates of growth in demand result in an increase in price. The Phillips curve therefore suggests a trade-off between inflation and unemployment. This means it is impossible to attain lower levels of unemployment but only at the expense of higher inflation.
Inflation targeting
New Zealand is credited with being the first country to adopt the monetary policy framework now referred to as inflation targeting. Since then several central banks in both developed and developing countries have adopted this framework.
Walsh (2009) reports that central banks that have made the choice of adopting inflation targeting policy are satisfied with that decision and believe that it offers numerous benefits. Most central banks, however, disagree with that position and argue that inflation targeting (IT) overly prioritises inflation to the detriment of other important monetary goals.
Recent macroeconomic developments and the financial crisis have strengthened the hands of the critics.
Juxtaposing these opposing arguments the question still remains unanswered as to whether IT matters. What empirical evidence exists in either developed or developing countries to serve as a proof or otherwise of the impact of IT on economic performance?
This paper discusses the effects of inflation targeting and lessons for monetary policy that can be drawn from Ghana’s central bank. I begin the discussion by asking, what is inflation targeting?
Inflation targeting – what is it?
The extant literature is littered with examples of both inflation targeting and non-inflation targeting countries focusing on achieving inflation objectives. Several researchers have variously defined inflation targeting. The bottom line is that the central bank must officially declare an inflation target and it must adjust its policy instrument with the aim of meeting its inflation target over some horizon. Inflation targeting focuses on nominal anchor directly with regard to the main objective of monetary policy, contrary to fixed exchange or the employment of monetary targets. Inflation targeting is not defined in terms of actual policy implementation as inflation targeting countries differ in terms of policy practices. Both the Banks of Canada and England, for example, purposely react to exchange rate movements whereas countries like Australia and New Zealand do not.
Transparency is another example in which inflation targeting countries differ. The central banks of Norway, Iceland, Sweden, New Zealand, and the Czech Republic usually publish forecasts for their policy interest rate whereas other inflation targeting countries find it unnecessary.
A common feature among inflation targeting countries is the fact that none of the central banks focuses only on meeting its inflation target without considering the real implications. Rather, inflation targeting central banks pay heed to both inflation targets, as well as real economic stability.
These central banks are referred to as flexible inflation targeting countries. In spite of this, some fiercest critics of inflation targeting have sought to portray inflation targeting as hypothesising that any increase in price should always result in an increase in interest rate.
However, empirical evidence from New Zealand seems to be inconsistent with such a simple-minded approach to inflation targeting policy.
For instance, there are specific conditions which warrant deviations from price stability. Some of these conditions have been identified as shift in prices as a result of government levies, external terms of trade price shocks, and movements in indirect taxes.
Central banks, whether adopting inflation targeting or not, continually encounter these shocks which present a challenge to aggregate demand management.
Perhaps, it is safe to conclude that whilst inflation targeting monetary policies may be good monetary policies, they cannot be considered as the only approach of conducting a good policy.
For instance, though inflation may be widely considered as the anchor of choice, the key issue is to have quantitative goal which may be exchange rate, money growth, interest rate or inflation. The choice taken to reach that goal is less important. GB
• The author is the Dean, Management Faculty - University Of Professional Studies, Accra And Vice President - Consumer Advocacy Centre.