Wednesday, February 12, 2014

Change in Expected Inflation and Its Effect on Investment and Spending

Greg Mankiw explained a possible tool for the FED to stimulate the economy under zero lower bound. He says that even the FED has already lowered the federal funds rate to close to zero, the monetary policy that creates a higher expected inflation in the economy could boost the economy. Mankiw explains that if the expected inflation is increased due to the FED's policy or other reasons, the real interest rate can be lowered. According to this argument, this lower real interest rate induces more investment because of negative correlation between real interest rate and investment. In his words:
"Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending."
How I see this argument is this: since a firm expects that the overall price in the economy to increase by more than  what it expected before, the firm would invest more in new capital than it was planning to do for two reasons: first, it would try to take advantage of low price more than it was planning before. In other words, since the firm expects the general price to go higher than it expected before, it will increase its today's investment to avoid paying this higher price in the future to buy capital. It is shifting its investment from the future to today. Second, when the firm's expectation of inflation increases, it would seek to borrow more money than it planned to do because the real interest it will pay in the future decreases. In other words, they just cannot resist this lower real interest rate in the future; therefore, they will borrow money today and invest in whatever plan they could think good.
The part I don't understand in Mankiw's argument is how the change in expected inflation could affect the real interest rate today.
In his General Theory, Keynes writes:
"The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. (p.142)
Keynes says that any possible affect of the increase in expected inflation on the investment is through the higher schedule of the marginal efficiency of capital. What I am understanding as the schedule of the marginal efficiency of capital is the firms demand for investment.
Now on the effect of higher expected inflation on consumption spending, it seems to be reasonable to expect that people would spend more today if their expectation on the general price rises. Of course, whether it is true or not depends on in what time period we are talking about the inflation expectation. If people raises their expectation of inflation in the near future, they try to adjust their spending accordingly. Also, the effect on consumption differs for durable goods and non-durable goods since the absolute change in the prices of durable goods tend to be higher than that of non-durable goods. Because of this possible effect on the spending, there could be increase in overall prices today. In other words, a higher expected inflation could cause increase in prices today. However, this possible positive relation between the change in expected inflation and spending isn't clear. In their paper in 2012, Bachmann et al concludes following: 
"We find that the impact of inflation expectations on the reported readiness to spend on durable goods is statistically insignificant and small in absolute value when compared to other variables, such as household income or expected business conditions. Moreover, it appears that higher expected price changes have an adverse impact on the reported readiness to spend. A one percent increase in expected inflation reduces the probability that households have a positive attitude towards spending by about 0.1 percentage points. At the zero lower bound this small adverse effect remains, and is, if anything, slightly stronger."
We still lack empirical study on the effect of the change in expected inflation on the spending. In my curiosity, I looked over some data on the monthly change in the expected inflation, quarterly percent change in the investment and monthly percent change in consumption spending.fredgraph (1)  From this graph, we cannot tell whether the higher expected inflation induces more investment or higher consumption spending. Of course, we need to do empirical research to claim whether it is true or not. In conclusion, I don't see or understand the stimulating effect of the higher expected inflation on the economy as Mankiw and others see it. Therefore in my opinion,  the effect of raising inflation expectation by monetary policy, which is one of the two main tools that some people suggest in today's case of zero lower bound problem, isn't clear. The other tool, quantitative easing, seems to be more effective under zero lower bound.

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