Price Level or Expected Changes in the Price Level

Some economists argue that the CB primary goal should be price stability. If so, an obvious possible target is the price level itself. The CB could target a particular price level or a particular rate of change in the price level and adjust its policies accordingly. If, for example, the CB sought an inflation rate of 2%, then it could shift to a contractionary policy whenever the rate rose above 2%.

Advocates of inflation rate targeting argue that it is important to focus not on the past rate of inflation or even the current rate of inflation, but on the expected rate of inflation.

A liquidity trap and quantitative easing

What if the CB cannot bring about a change in interest rates? A liquidity trap is said to exist when a change in monetary policy has no effect on interest rates. This would be the case if the money demand curve were horizontal at some interest rate, as shown in Figure A Liquidity Trap. If a change in the money supply from M to M ’ cannot change interest rates, then traditional monetary policy is rendered totally ineffective. At an interest rate of zero, since bonds cease to be an attractive alternative to money, which is at least useful for transactions purposes, there would be a liquidity trap.

In this case the central bank can pursue additional, nontraditional measures. The aim is to make firms and consumers want to spend now by using a tool not aimed at reducing the interest rate. It thus shifts its focus to the price level and to avoiding expected deflation. For example, if the public expects the price level to fall by 2% and the interest rate is zero, by holding money, the money is actually earning a positive real interest rate of 2% - the difference between the nominal interest rate and the expected deflation rate.

Figure A Liquidity Trap

To combat this “wait-and-see” mentality, the central bank, using a strategy referred to as quantitative easing, must convince the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation. In other words, it is aimed at creating expected inflation. If it is successful, this extraordinary form of expansionary monetary policy will lead to increased purchases of goods and services, compared to what they would have been with expected deflation. Also, by providing banks with lots of liquidity, it is hoping to encourage them to lend.

The Japanese economy provides an interesting modern example of a country that attempted quantitative easing. With a recessionary gap starting in the early 1990s and deflation in most years from 1995 on, Japan’s central bank, the Bank of Japan, began to lower the interest rate, reaching near zero by the late 1990s. With growth still languishing, Japan appeared to be in a traditional liquidity trap. In late 1999, the Bank of Japan announced that it would maintain a zero interest rate policy for the foreseeable future, and in March 2001 it officially began a policy of quantitative easing. In 2006, with the price level rising modestly, Japan ended quantitative easing and began increasing the interest rate again. It should be noted that the government simultaneously engaged in expansionary fiscal policy.

How well did these policies work? The economy began to grow modestly in 2003, though deflation between 1% and 2% remained. Some researchers feel that the Bank of Japan ended quantitative easing too early. Also, delays in implementing the policy, as well as delays in restructuring the banking sector, exacerbated Japan’s problems.

Key concepts

· Macroeconomic policy makers must contend with recognition, implementation, and impact lags.

· Potential targets for macroeconomic policy include interest rates, money growth rates, and the price level or expected rates of change in the price level.

· Even if a central bank is structured to be independent of political pressure, its officers are likely to be affected by such pressure.

· To counteract liquidity traps, central banks have used quantitative-easing.