Tutorial 8 Memo
Question 1:
“The kink in the inflation–growth relation for the poor countries is more likely to differ
from the one for the rich countries where prices (including wages and prices of other
factors) are generally inflexible downward, where traditions governing the ‘normal’
price are more widespread, and where the nominal private and public institutions,
such as employment contracts, social security and the taxation system, Inflation-
Growth Profiles Across Countries 193 are more developed as are the indexation of
these institutions to price changes” (Dorrance, 1966).
a) Considering the statement above and the figures below, discuss the pros and
cons of the inflation targeting policy in the context of a country moving
towards development.
Hint: Also think about unemployment rate and remember that life is not that
nice.
Pros:
If the Reserve Bank were able to achieve the inflation target precisely the
unemployment rate would be equal to its natural rate. Hence, by targeting and
achieving a constant rate of inflation in line with expectations, the Reserve Bank also
keeps the unemployment rate at its natural rate and by implication keeps output at its
potential.
Cons:
However, because life is not that nice, there are times that inflation will be above the
target and output below its potential. This then makes the Reserve Bank tasked with
the decision of decreasing inflation and adopting a tighter monetary policy or to
increase output and adopt an expansionary monetary policy.
Link to developing nations:
Some Reserve Banks are tasked with the single mandate of maintaining stable and
low inflation rates, whilst others have a dual mandate to stable and low inflation as
well as keeping output as close as possible to its potential.
For a developing country lowering the inflation rates boosts economic growth. As
depicted in the graph below for low-middle income countries when the inflation rates
are higher the economic growth is low and when the inflation rates are lower,
economic growth increases. Based on the figure provided maintaining lower inflation
would be beneficial to developing countries.
b) Now consider that you as a policymaker you decide contain price stability through
interest rate, discuss could that be achieved using the Taylor rule.
If inflation is equal to its target and the unemployment rate is equal to
its natural rate of unemployment, then the central bank should set the
nominal interest equal to its target value.
If the inflation rate is above the target, then the central bank should
increase the nominal interest rate above the target nominal interest
rate. This higher interest rate will increase unemployment and this
increase in unemployment will lead to a decrease in the inflation rate.
The coefficient a reflects how much the central bank cares about
inflation. The higher a is, the more the central bank will increase
interest rate in response to inflation, the more the economy will slow
down, the more unemployment will increase, and the faster inflation will
return to the target inflation rate.
If unemployment is higher than the natural rate of unemployment, the
central bank should decrease the nominal interest rate. The lower
nominal interest rate will increase output, leading to a decrease in the
unemployment rate. The coefficient b should reflect how much the
central bank cares about unemployment. The higher b is, the more the
central bank is willing to deviate from target inflation to keep
unemployment close to the natural rate of unemployment.
Question 2:
a) List the costs of inflation and discuss one of your choice.
The costs of inflation are as follows:
Shoe-leather costs:
This refers to the time and effort that people spend trying to counter the
effects of high inflation, which leads to higher interest rates, which results in
higher opportunity cost of holding money. They do this by trying to hold less
money and must make additional trips to the bank. These constant trips to the
bank would be avoided if inflation were lower and people could be doing other
things instead, such as working or enjoying their leisure time.
Tax distortions:
This cost comes from the interaction of the tax system and inflation. These
are taxes that do not adjust for inflation. Taxes on capital gains are typically
based on a change in price in dollars of the asset between the time it was
purchased and the time it was sold, not the inflation-adjusted increase. So
essentially, the higher the inflation the higher the tax. Inflation also increases
the tax rate paid on interest income. People are pushed into higher tax
brackets as their nominal income increased, and not as their real income
increases.
Money illusion:
This is the notion that people have a tendency to view their wealth or income
and interest rate in nominal terms and not in real terms. This means that
people don’t take into account inflation, believing the Rand they hold has the
same value as last year.
Inflation variability:
This means that financial assets such as bonds that promise to make a fixed
nominal payment in the future becomes riskier. When inflation is constant, the
real value of the bond after a certain number of years is known. With varying
inflation, the value of the bond after a certain number of years will be
uncertain.
b) Suppose you have a mortgage of R50 000. Expected inflation is π e and the
capital-gain tax is 30%, consider two cases:
e
i) π =0
7
50 000 ( 1+0 ) −50000
Effective tax rate = ( 0.3 ) x 7
50 000 ( 1+ 0 )
Effective tax rate = 0
e
ii) π =12
7
50 000(1+ 0.12) −50 000
Effective tax rate = ( 0.3 ) x
50 000(1+0.12)7
Effective tax rate = 16.43%
Question 3:
List the benefits of inflation and discuss one of your choice.
The benefits of inflation are as follows:
Seignorage: which is money creation, the ultimate source of inflation. It may be
counted as positive revenue for a government when the money it creates is worth
more than the cost to produce the money. The other benefit of this is that the
government does not have to rely on taxation to fun their expenditure, so it lowers
taxation.
The option of negative real interest rates: an economy with higher interest rates
can counter economic shocks because it has room to lower interest rates to fight a
recession. A country with lower average interest rates does not have the same
amount of room to manoeuvre.
Money illusion in facilitating real wage adjustments: when there is a positive
inflation rate, firms or employers can use this to their advantage. The inflation allows
for real wage reductions whilst the workers who look at their income in nominal terms
do not recognise that taking inflation into account their wage (real wage) is actually
decreasing. So, inflation allows for these negative real wage adjustments.
Question 4:
Discuss what are the potential problems of unconventional monetary policies such
as quantitative easing on emerging markets such as South Africa
Unconventional monetary policies have seemed to work in advanced economies,
however there are some potential negative impacts for emerging nations.
Unconventional monetary shocks lead to significant effects on financial variables in
emerging market economies such as the exchange rate appreciation, reduction in
long-term bond yields, stock market boom, and increase in capital inflows to these
countries.