The collapse of the U.S. economy into the liquidity trap has put into question several macroeconomic thoughts that were taken for granted before the onset of the 2007-2009 Great Recession. Some of these thoughts have been explained in Part I in this blog.[1]   Two more will be discussed in this post. One of those long held thoughts is the revealed preference for a low and stable inflation in the range of 2 percent. This goal has been deemed necessary to keep inflation stable and inflation expectations in check. Policy makers know that if inflationary expectations are allowed to rise, it will be very difficult to overcome them.  Now the new thought is that an inflation rate in the range of 3-4 percent is preferable because this range can give the monetary authority sufficient room to drop interest rate down to stimulate the economy before it falls into the liquidity trap. An advocate of this new thought are the IMF chief economist Olivier Blanchard and the Noble Laureate Paul Krugman.  The Noble Laureate views the interest rate as a very powerful tool to stimulate the economy outside the liquidity trap. In fact, Goldman Sachs asserts that it takes between $1 trillion and $1.6 trillion of unconventional easing to achieve as much as the Fed can accomplish in normal times, by reducing the Federal funds rate by a one percentage point.[ii]

The higher inflation idea has received more support from those who think that one of the ways to reduce the huge U.S. government deficit, which is approaching 10 percent of GDP, is to inflate the debt. Under high inflation, real money loses value and this makes it easier for borrowers to pay their debt.

This new idea is still opposed by the old guard who thinks that an inflation rate in the range of 3-4 percent may generate inflationary expectations in the range of 5-6 percent which could lead to unmanageable inflation. This group also thinks that higher inflation may increase the cost of debt by increasing the interest rate. In such an environment, there would be  a strong need for fixed interest rates.

In most of  the economic literature, costs of high inflation outweigh its benefits. Inflation has five well-known costs and three benefits. One of the costs is the shoe leather cost imputed in terms of the time and effort of going (or walking) to the bank to spend the available cash because it keeps losing its real value. However, this opportunity cost has been reduced with availability of  Internet shopping. Another cost is the distortion in tax brackets which makes people pay more taxes than they would relative to what actually make in real terms. This distortion can be fixed by indexing. A third cost is money illusion where people look at their nominal income instead of the purchasing power of their income. The fourth cost  is the one  related to inflation expectations and inflation uncertainty which reduces investment and household spending. The final cost is the distribution cost from creditors to debtors which includes inflating the government debt.

The three benefits of inflation include seigniorage as an inflation tax, negative real interest rates and real wage adjustment under money illusion. The command over societal resources, or the purchasing power realized by issuing new money, is known as seigniorage. Keynes described  seigniorage as the insidious ability of governments to raise revenues by inflating their currencies.  He wrote about a country's ability to "live for a long time . . . by printing paper money;" in fact, it can "live by this means when it can live by no other".  Negative real interest rate (NRIR) should increase business investment which leads to higher economic growth in the long run. NRIR should also benefit resource economies because it increases the demand for gold and other commodities.  Finally, lower real wages under money illusion would allow firms to hire more workers in periods of high inflation. In sum, putting the above costs and benefits on the two sides of a scale, I see the proposed 3-4 percent inflation to be costly because of its impact on inflation expectations. Moreover, Great Recessions are very rare and may happen once in 80 years and may happen less after each time it happened because of the preventive measures taken consequently.  In a liquidity trap, heaviy lifting is expected from fiscal policy. Putting all these fators togther, does the cost of ouput loss of being in a liquidity  trap for two years outweigh the cost of having higher inflation for 80 years?

Another idea that came out of the post Great Recession debate is the importance of using both countercyclical fiscal and monetary stimuli to combat recessions that follow financial crises. These recessions are damaging in the long run and are usually associated with global downturn.[iii]  Applying the double-stimulus can reduce the loss in output in the medium term. Even now, more and more people are accepting the view that the $787 stimulus package has helped the economy from getting worse and may have prevented it from slipping into a Great Depression.  While almost everyone agrees that fiscal policy burden the public debt, there is no agreement on how much will this last in the medium and long run.

These issues will be debated in the macroeconomic literature for many years to come. Research papers one after another will be published before better thoughts on the desired level of inflation and the coordination of fiscal and monetary policies will emerge in the economic literature.

[i] http://www.zawya.com/blogs/shawkat.hammoudeh/100214214114/