I recently participated on a panel in London, discussing options for monetary and fiscal policy. At one point I mentioned that if the Japanese didn’t want such a large central bank balance sheet, then they ought to set a higher inflation target. (Of course I’d prefer an NGDP target, but it was easier to explain my point using their currently preferred target variable.)

Someone in the audience objected that higher inflation would hurt elderly Japanese on fixed income, and this might reduce aggregate demand. In contrast, I think it would boost consumer spending in Japan. Furthermore, I believe the audience member was reasoning from a price change, whereas I was not. Why?

The audience member made the mistake of thinking about the impact of inflation, without thinking about the cause. If the cause had been disruption to Japanese production from the 2011 tsunami, then his reasoning process would have been correct. (Although in that case the impact would have been too trivial to mention. Even the most massive natural disasters have only a tiny impact on macro variables in large diversified economies.) However, in my hypothetical the inflation was caused by monetary stimulus, not an adverse supply shock.

An increase in inflation caused by an expansionary monetary policy will first shift the AD curve to the right. In the short run output may increase, due to sticky nominal wages. Even if output does not rise, it will certainly not decline as a result of higher AD. It is inflation from adverse supply shocks that causes people to buy less stuff.

Japanese unemployment has recently fallen to 3%, so I would certainly not recommend monetary stimulus in Japan for the purpose of boosting employment. But I might recommend it for three other reasons:

1. Ease the burden of the national debt
2. Reduce the zero bound problem for monetary policy
3. Reduce the role of the BOJ in the Japanese economy.

In normal circumstances, it is not wise to inflate away the debt. It is unfair to lenders, and reduces policy credibility. In the case of Japan, however, previous deflation unfairly favored borrowers, and steeply increased the ratio of public debt to GDP. A modest amount of inflation is justified in that case—but nothing more than 3% in my view. In addition, when the interest rate is zero, the equilibrium rate is often below zero, which means that lenders to the Japanese government are earning an above equilibrium rate of return. A bit more inflation can prevent that.

2. If the Japanese shifted to NGDPLT and/or abandoned the short-term interest rate as a monetary instrument, then the zero bound problem would not be an issue. But as long as they use interest rates to target inflation, monetary policy becomes less effective at very low inflation rates. Thus if they refuse to adopt a sensible monetary policy, then a slightly higher inflation target might make sense as a way of keeping the policy rate above zero, a sort of “second best” policy.

3. The size of the BOJ balance sheet is inversely related to the trend NGDP growth rate. In recent years the balance sheet has become huge, with the BOJ even buying equities. I prefer less government involvement in the economy, and hence a smaller balance sheet. That means a slightly higher inflation target.

As I keep emphasizing to conservatives, it’s socialism or inflation.