Understanding Inflation: Implications for Monetary Policy

Abstract

This paper discusses how optimal monetary policy is affected by differences in the combination of shocks an economy experiences and the rigidities it exhibits. Without both nominal rigidities and economic shocks, monetary policy would be irrelevant. Recognizing this, policymakers increasingly incorporate the understanding gained from new research on rigidities and shocks into both their policy actions and the design of monetary institutions. Specifically, shocks can be predominantly real, affecting relative prices, or primarily nominal, moving the general price level. They may also be big or small, frequent or rare. Similarly, some nominal rigidities are symmetrical, affecting both upward and downward movements equally, while others are asymmetrical, restricting decreases more than increases. After reviewing major trends in the conduct of monetary policy, we describe how the growing theoretical and empirical literature on shocks and rigidities informs three crucial dimensions of monetary policymaking. First, we discuss why trimmed means provide the best measure of core inflation. Second, we outline how rigidities impede policymakers' ability to control inflation.And third, we describe how alternative shock/rigidity combinations create inflation's grease (whereby it improves economic efficiency by speeding adjustment) and sand effects (whereby it distorts price signals) with their contrasting implications for the optimal level of inflation. We conclude by considering some key implications for monetary policy.

Monetary Policy in a Changing Environment

“…Intermarket data are the most relevant for imperfect information induced sand effects, while staggering should also affect intramarket data. Cecchetti and Groshen (2000) also point to the fact that sand effects should be symmetrical, while grease effects may have an asymmetric impact, as they facilitate downward adjustment in particular. With this in mind, our result that the chronic right skewness is largely endogenous, rather than resulting from presumed downward rigidities, considerably reduces the scope for substantial grease effects.…”

“…13 See, for instance, Chatelain et al (1996) and Le Bihan and Sédillot (1999) for France, Roger (1997) and Roger (forthcoming) for New Zealand, Kearns (1998) for Australia, Marques and Mota (2000) for Portugal, Meyler (1999 for Ireland, and Vega and Wynne (2001) for the euro area as a whole and for participating countries. In contrast, in the United States the distribution is symmetric (Cecchetti and Groshen (2000)).…”

Towards a More Neutral Monetary Policy: Proposal of a Nominal Income Rule1

“…Both situations, corresponding to the delay in the transmission of relative price changes and a biased transmission channel, may misdirect monetary policy-makers (Cecchetti and Groshen, 2001). Under these circumstances, the CPI can follow a path, especially in the short run, but also in the long run, which is not related to the changes of market prices, so it cannot be used properly to monitor and evaluate the purchasing power of money.…”

The Old and the New in U.S. Economic Expansion of the 1990s

“…The four years of recovery through 1994 saw a rise of 26 percent only, but the boom that followed caused a surge in taxes totaling $553 billion or some 6.5 percent of the avenge GDP for the period. Recent changes in the levels and progressivity of the tax rates, and shifts of people into higher brackets, resulted in more of See Sims 1992, Cecchetti 1996and Cecchetti and Groshen 2000, for evidence and discussion. M3 includes currency, checking deposits, NOW accounts, and travelers checks; small time deposits, savings deposits, money market mutual fiands, and overnight repurchase agreements; large time deposits, overnight and term Eurodollars, and tenii repurchase agreements.…”