Posted by: Dirk | February 17, 2010

Higher inflation = more room for interest rate cuts?

Here is the evidence for some countries of the eurozone. As you can clearly see, countries with above average inflation rates before the crisis (like Ireland and Spain) turn out to be among those with the lowest inflation rates during the crisis. Countries like Germany and France had relatively low inflation and are now among those with relatively high inflation. The point is: some countries have a high inflation volatility, others don’t. So, it’s hard to believe that some economists argue that those countries with higher inflation would have more room to cut nominal inflation rates (which is not the case in the eurozone, but that’s not the point). What matters for the transmission of monetary policy is the real interest rate, and if even high inflation is turning quickly into deflation you are stuck with the same problem as before: non-sufficient effective demand. Apart from that, I still don’t get it: how can you combine high inflation and high interest rates for a longer period holding everything else constant?

The frame of reference is this:

IMF survey online: Central banks have chosen low inflation targets, around 2 percent. In your paper, you argue that maybe we should revisit this target. Why?

Blanchard: The crisis has shown that interest rates can actually hit the zero level, and when this happens it is a severe constraint on monetary policy that ties your hands during times of trouble.

As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now if whether this could justify setting a higher inflation target in the future.


  1. “I still don’t get it: how can you combine high inflation and high interest rates for a longer period holding everything else constant?”

    Gute Frage; das habe auch ich bei Blanchard nicht kapiert, denn schließlich erhöhen doch die Notenbanken üblicherweise die Leitzinsen zum Zwecke der Inflationsbekämpfung!

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