Academic journal article Federal Reserve Bank of St. Louis Review

The Costs and Benefits of Price Stability: An Assessment of Howitt's Rule

Academic journal article Federal Reserve Bank of St. Louis Review

The Costs and Benefits of Price Stability: An Assessment of Howitt's Rule

Article excerpt

The central banks of New Zealand, Canada, and the United Kingdom have recently decided to make price stability the overriding goal of monetary policy. Similar proposals in the United States have received a lukewarm reception. Although some opponents have argued that moderate inflation is beneficial, many concede its effect on economic welfare is detrimental.(1) Instead, they argue that a price stability policy is suboptimal because, once inflation is under way, it is better to tolerate some moderate inflation than to bear the cost necessary to achieve price stability. Howitt's Rule is the clearest statement of the proposition that the benefits resulting from reducing inflation must be weighed against the cost of reducing it.(2) (See the shaded insert, "Howitt's Rule.")

Assuming inflation affects both the level and growth rate of output, I state Howitt's Rule and explain how it argues for a continued policy of moderate inflation. Next, I analyze alternative estimates of the costs of achieving price stability and compare these costs with estimates of the gain from achieving price stability when inflation reduces the level or growth rate of output. Finally, I briefly review the cross-section and time-series evidence on the effects of inflation on output growth. In the final section I offer a summary and some concluding observations.

THE COST-BENEFIT INFLATION TRADE-OFF: HOWITT'S RULE

Howitt (1990) argues that, although inflation is costly, once it is under way, society is better off to tolerate a little inflation than to bear the cost necessary to achieve price stability. Howitt (1990, p. 103) notes, "There are a host of reasons why the best average rate of inflation, ignoring costs of getting there, is zero . . ." (italics added). Arguing that the cost of achieving zero inflation may be substantial, however, Howitt suggests his rule can be used to determine the "optimal" inflation rate.

Howitt argues that the transitions cost "will not be negligible, so that it will be optimal to stop disinflation, even when the gain from further reduction is still positive." Therefore, Howitt (1990, p. 104) concludes, "The optimal target is probably somewhere above zero" (italics added).

The cost-benefit trade-off Howitt alludes to is represented in Figure 1 (under the assumption that inflation reduces the level of output). At time to policymakers decide to pursue a policy that will reduce the steady-state inflation rate from its current level to a lower level, perhaps zero. This change in policy causes output to fall below its steady-state path until time [t.sub.1], when the economy achieves its new lower inflation rate and a permanently higher level of output.(3) The permanent increase in the level of output is taken to be some proportion, [Theta], of current period output, that is, the increase is equal to [Theta][y.sub.0]. The shaded area marked G represents the permanent gain to output associated with achieving a lower rate of inflation for a given time horizon (T). The shaded area marked L denotes the temporary output loss associated with reducing the steady-state inflation rate.

Discounting Future Output

Howitt's Rule states that disinflation should continue until the present value of G equals the present value of L. Hence, the output levels in Figure 1 must be discounted at some discount rate, [Beta]. Figure 1 can be easily modified to show the effect of discounting. This is done in Figure 2, which shows the present (time [t.sub.0]) value of the output streams in Figure 1 discounted at the rate [Beta]. Figure 2 assumes that the discount rate is larger than the growth rate of output, [Alpha], so the present value of future output always lies below current output.

Under this assumption, the present value of future output approaches zero as the time horizon approaches infinity, T [approaches] [infinity]. This is true for both the high- and low-inflation output paths. Consequently, the present value of the gain from reducing inflation, pvg in Figure 2 (the shaded area between the present values of these alternative output paths), is finite. …

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