LONDON (MNI) – A Bank of England working paper argues against
using monetary policy aggressively to tackle inflation blips when
these are due to adverse productivity shocks.
The paper, published Wednesday, finds evidence of a trade-off
between inflation variability and output variablity, and argues that
optimal policy should allow a small temporary rise in inflation in the
event of a negative productivity shock. The cost of being too aggressive
tackling inflation can be large.
The paper, by Gertjan Vlieghe, highlights the importance of nominal
rigidities and credit frictions in setting optimal policy – accepting
the reality and signficance of far from perfect markets.
The author states “I have shown that the presence of both nominal
rigidities and credit frictions can lead to a trade-off between
inflation variability and output variability.”
His research shows if “an output fall leads to a reallocation of
resources toward less productive agents, it will result in large future
deviations of output from its efficient level. So there is a trade-off
between the rise in inflation immediately following the shock, and the
fall in future output relative to its efficient level.”
The implication for policymakers is they should, at times, be
prepared to allow a brief rise in inflation in order to facilitate
greater stability in future.
“Allowing a small temporary rise in inflation following an adverse
productivity shock is optimal, because it results in output being much
closer to its efficient level in future periods,” the paper says.
“A large reduction in output variability can be achieved by
allowing only a small amount of inflation variability. Conversely, the
cost of stabilising inflation too aggressively can be large,” the paper
states.
The full paper is available on the following link:
http://www.bankofengland.co.uk/publications/workingpapers/wp385.pdf
–London newsroom: +44 207 862 7499; e-mail: drobinson@marketnews.com
[TOPICS: M$B$$$,M$$BE$]