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What is the optimal rate of inflation?

For the last decade, New Zealand has pursued a goal of low inflation in the belief that this approach is better for a country's economy than high inflation.

Associate Professor Bob Buckle of Victoria University's School of Economics and Finance says it is widely considered that inflation imposes costs on an economy. There is extra uncertainty, income distribution is affected and the tax scales become distorted. Firms have to change prices more frequently, costing money in management time and in reprinting and distributing new price lists.

However, he says, there is also a widely held view that inflation "greases the wheels of wage and price changes". In other words, inflation makes it easier to bring about relative changes in prices and wages.

In a climate of inflation, a firm will attract little attention if it raises prices more than its staff wages, or costs. With zero inflation, it's much more apparent when firms raise or lower their prices or wages. So, in circumstances where relative price changes can improve the allocation of resources, it must be asked whether a bit of inflation is a good thing?

Crucial to finding an answer to this question is an understanding of firms' behaviour with regard to price and production changes - and whether they behave the same way in times of high inflation as they do in periods of low inflation.

In a study supported by a research grant from the Reserve Bank of New Zealand, Associate Professor Buckle has been examining the pricing and production behaviour of New Zealand firms under different inflation conditions, in collaboration with John Carlson of Purdue University in the United States.

Their research is unique as individual firm data over more than 30 years was used to evaluate the effect that inflation has on the frequency with which firms change prices. It also looks at whether the way prices and production respond to cost and demand shocks is different in times of high and low inflation.

The data, rarely available in this form, came from quarterly surveys run by the New Zealand Institute for Economic Research since 1963. These surveys recorded individual firms' information about their changes in prices, cost, demand and production, and also their expectations of such changes.

The two researchers undertook statistical modelling using this micro-level information across general inflation rates that ranged from about one percent to 16 percent per annum.

The research shows that firms change prices more frequently when inflation increases. More importantly, they find pervasive evidence that inflation induces an "asymmetric" pricing and production response by firms.

In times of higher inflation, firms are more likely to raise prices in response to rising costs and demand, but they are less likely to lower prices in response to reduced costs and demand. In terms of firms' production levels, responses to cost and demand shocks also vary with inflation. In particular, if demand drops then firms are more likely to cut production - and therefore their workforce - than to reduce prices in periods of high inflation compared to periods of low inflation.

Therefore, inflation does seem to "grease the wheels" of price changes, but only in one direction. For this reason, inflation can result in changes in demand and firms' costs having adverse effects on resource allocation and employment. These "asymmetries" and adverse effects on resource allocation tend to disappear as inflation falls; that is, during low inflation a firm is more likely to reduce its prices in response to a drop in demand, instead of cutting production. This is understood to be the first time this effect has been demonstrated from micro-level firm data.

"These results are important in helping to understand the optimal inflation rate and the appropriate inflation target for monetary policy," Buckle says. "They are also important in helping understand the output and employment costs associated with disinflation policies."

When the Reserve Bank decides that inflation is running too high, it takes measures to reduce inflation - primarily by increasing interest rates, and thereby causing a general drop in demand. This leads to a bigger drop in production and corresponding fall in employment when inflation is high than if inflation had been low. This is one reason why it is better to keep inflation low all the time, Buckle says - if inflation gets away, the cost of fighting it has a bigger negative effect on the economy in the way of a larger fall in production and employment.

These results also imply that costs in the form of lost output and employment arising from the use of monetary policy to keep inflation low may be significantly smaller than the consequential costs of allowing inflation to fluctuate widely as it did in the past and having to restore low inflation.

There may be better and less costly ways the Reserve Bank can use to keep inflation at low rates. Nevertheless, "these results show that the objective of low inflation might well be optimal," Associate Professor Buckle says.

Another important insight from the study is that firms' behaviour can be very different in differing inflation climates. This needs to be taken into consideration when economists develop models of the economy and use these models for forecasting. Buckle is also exploring other ways the survey data can be used to gain further insights into the behaviour of firms, such as the way size influences decisions.

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