certainty. Moreover, inflation tends to be more variable and relative prices subject to larger changes when overall inflation is high than when it is low. To the extent that inefficiencies in business planning are a major concern, an index that somehow combined both input and output prices would be desirable conceptually, perhaps supplemented by some measure of the variation in relative prices. But since the cross-sectional and time-series variations in inflation tend to be positively correlated with the overall inflation rate, some broad measure of inflation—the CPI or the price index for GDP—is a suitable indicator for purposes of monetary policy. The Technical Note at the end of this chapter compares the GDP price index, the CPI, and the NIPA price index for consumer expenditures as measures of inflation.

Over the last 10 to 15 years, central banks of the economically advanced countries have increasingly come to define their principal, if not always sole, objective as the pursuit of low and stable inflation rates. In some countries these are embedded in numerical targets set by law. The U.S. Federal Reserve has no statutory numerical target, but it does seek a low inflation rate as a top-priority objective.25 Even if modest changes in inflation may not be harmful to macroeconomic performance or consumer welfare, charging the central bank with achieving sustained low inflation is likely to be desirable. It may, for instance, reduce the temptation to adjust macroeconomic policy to avoid politically difficult decisions by allowing inflation to inch persistently upward.

When inflation strongly overshoots a central bank’s targets, “errors” of 0.5 or 1 percent a year in measuring inflation clearly do not matter very much—the steps the central bank ought to take are obvious. But when inflation is in the general neighborhood of the target, small measurement differences can loom large in policy making (which would necessarily be the case if the inflation target were set in law). In this view, the monetary authorities would mistakenly restrict the economy if inflation were above the target due to measurement error, whereas such restrictive policy would be unnecessary if the inflation measure were “corrected” to remove the source of error. Because the transition costs of pushing the inflation rate down by, say, a further 1 percent are very substantial, the magnitude of any upward bias in the inflation index can be a critical question of monetary policy. It is not at all clear, however, that this is a correct view of how monetary authorities should react to a change in index measurement techniques.

25  

The Federal Reserve Act directs the Federal Reserve to seek “to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” But as the Federal Reserve Board has stated, “A stable level of prices appears to be the condition most conducive to maximum sustained output and employment and to moderate long-term interest rates” (Federal Reserve Board, 2000). History makes it clear that the Federal Reserve considers an inflation rate persistently in the very low single digits to be consistent with the statutory objective of “stable prices.”



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