Friday, May 23, 2008

Megan McArdle vs. Joseph Stiglitz

Joseph Stiglitz thinks inflation targeting is a bad idea. Megan McArdle thinks inflation targeting isn't such a bad idea. Stiglitz argues that inflation targeting is especially inappropriate for developing countries because most of their inflation is imported:

Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries.
McArdle counters by noting that higher food and energy prices don't always lead to higher inflation:
[I]nflation in the general price level is a result of there being more money than demand for money. Sudden scarcity--which is what higher food and energy prices represent--results in a shift in the relative value of everything in the economy.
The problem with this argument is that higher food and energy prices aren't always the result of sudden scarcity. Higher food and energy prices are sometimes the result of inflation, and sometimes the result of sudden scarcity. It's true that the Fed pays more attention to core inflation -- which excludes food and energy prices -- than headline inflation, but the Fed also hasn't adopted strict inflation targeting. Ultimately, I think Stiglitz and McArdle are probably both right in a sense. Stiglitz is right that inflation targeting is inappropriate as a one-size-fits-all rule, and is especially inappropriate for developing countries. Firms with sufficient market power can raise prices above marginal cost, and firms are much more likely to have sufficient market power in developing countries (because markets in developing countries tend to be thin). When higher prices are the result of this kind of mark-up, then the price level and the output gap are moving in opposite directions. In this scenario, inflation targeting would prevent the central bank from achieving a stable output gap. However, McArdle is right that inflation targeting isn't always and everywhere a bad idea. As always, context is king.


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