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Question: Some economists have argued that the Federal Re3serve should raise its inflation target from 2 percent to 3 or even 4 percent. Why might the effect of a higher inflation target on the quantity of real money balances demanded be larger in the long run than in the short run?
READER COMMENTS
Thomas L Hutcheson
Apr 1 2025 at 12:38pm
What an odd question to ask. One might wonder if 3% or 4% PCE (0r some other metric) is closer to the real income-maximizing average inflation target than 2% PCE and the change would presumably have an effect on real money (M1?) balances which would depend on whether part on the change _was_ closer to the real income-maximizing target and the income elasticity of demand for real money balances.
If the higher rate is a movement away from the income maximizing target, then the price and income elasticities work in the same direction and the longer they work the more effect they have. OTOH if the change it toward a higher income state the income and price elasticities work in opposite directions and (the safe answer to most empirical questions in economics 🙂 “it depends on the elasticities.”
Bryan Cutsinger
Apr 1 2025 at 6:56pm
Thomas,
You bring up an important consideration. That said, whatever these income effects are, I suspect they’re probably quite small. Thus, my answer will ignore any income effects stemming from changes in the inflation target on the demand for money balances, and will focus instead on the role of substitutes. Thanks for your comment!
Bryan
David Seltzer
Apr 1 2025 at 1:50pm
Bryan: Using this definition, inflation is the rate at which the general level of prices for goods and services is rising, resulting in the decrease of the purchasing power of a currency. Your question: “Why might the effect of a higher inflation target on the quantity of real money balances demanded be larger in the long run than in the short run?”
Nominal interest are real rates plus anticipated inflation. If inflation increases nominal rates, the quantity of money demanded will decline as the cost of borrowing increased.
Currency debasement: It seems the quantity of money demanded would be lower in the longer term than the short term. Many individuals might swap dollars for assets to ameliorate their loss of purchasing power. To wit. Assume short term is two years 4% inflation target. (.96)^2 =.9261. Debasement =(1- .9261) = 7.84%.Assume long term is five years. 4%. (.96)^5 = .815. Debasement =(1-.815) = 18.46%.
The effect(s) of the higher inflation targets for both short run and long run are severe.
Short term (2 years) loss of purchasing power means one needs $1.106 to purchase $1 in goods and services.
Long term (5 years) loss of purchasing power means one needs $1.226 to consume $1 in goods and services. My grasp of this stuff is pretty tenuous.
Bryan Cutsinger
Apr 1 2025 at 6:59pm
David,
I think we are thinking about this question the same way. Swapping currency for assets could take time, especially if households have not already incurred the fixed costs of opening a brokerage account, for example. Thanks for commenting!
Bryan
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