Inflation Policy
Less Painful Policies

Anti-inflationary policies pursued by a single country can often have 'spillover' effects on other economies. Such policies while desirable for one country considered in isolation may be less so when these spillovers are taken into account. In Discussion Paper No. 55, Research Fellow Willem Buiter considers how desirable anti-inflationary policies should be designed in a two- country interdependent economic system. He explores the manner in which the optimal anti-inflationary policy depends on the nature of the price formation process, by considering models incorporating different degrees of sluggishness in the price level or in the rate of inflation.

Buiter first analyzes a 'classical' model in which prices are flexible. The financial and goods markets are forward-looking in their behaviour, and expectations are formed rationally. Suppose the 'home' country unilaterally announces an immediate and permanent reduction in current and future monetary growth. If this announcement is credible, it will lead to immediate costless and sustained reduction in the rate of domestic inflation equal to the reduction in monetary growth. If real balance effects are present in the model, however, the world real interest rate will rise as a result of the reduction in monetary growth, and domestic competitiveness deteriorates.

Buiter next considers a model in which there is a predetermined or 'sticky' price level but flexible 'core' rate of inflation. In this model a credible announcement of an immediate and permanent reduction in home country monetary growth is necessary for an immediate, costless, sustained reduction in domestic inflation by the same amount. In addition, the authorities must either increase the real money stock or adjust fiscal policy so as to prevent a decline in the domestic nominal interest rate. The 'sticky' price level means that this is not sufficient to remove inflation; provided that no real balance effects are present in the model, the first policy does avoid international spillover effects. It can be achieved either by immediate 'jump' in the nominal money stock or by 'Okun-style' direct or indirect tax cuts, with all fiscal variables adjusted to keep aggregate demand equal to full employment supply.

If there is both a 'sticky' price level and a sluggish 'core' rate of inflation, tax cuts (or incomes policy where feasible) must be implemented in order to eliminate core inflation. Anti- inflationary policy should include a credible, sustained reduction in monetary growth. The money stock should also 'jump' to accommodate the lower velocity associated with a successful transition to lower inflation. The presence of a sluggish rate of inflation in this model means that without cost-reducing tax cuts or incomes policy, costless disinflation is impossible; excess supply or expectations of future excess supply are required to reduce inflation. Even when a costless disinflation (or a disinflation at full employment) is feasible, it may be gradual rather than instantaneous. Depending on the authorities' objectives, they may prefer to purchase a faster reduction in inflation at the cost of some transitional unemployment.

Buiter emphasizes that for any single country a unilateral appreciation of its real exchange rate through tight money or expansionary fiscal policy may appear an attractive way of reducing the output and unemployment cost of bringing down inflation. Real exchange rate appreciation is a zero-sum game, however: one country's gain is another's loss. Buiter argues for of cooperative policy design which leaves the national authorities with approximately the same scope for influencing domestic target variables that they would have had in a closed economy.


International Monetary Policy to Promote Economic Recovery
Willem H Buiter

Discussion Paper No. 55, March 1985 (IM)