Wages and Prices and the Proper Conduct of Monetary Policy

Inflation plays a vital role in macroeconomics and financial markets. First, it is the only variable that is targeted by all main central banks. Accordingly, it determines the policy interest rates and hence short-term money market rates, which, in turn, influence the entire maturity spectrum of interest rates that potentially affect all components of aggregate demand as well as the demand for assets. Second, the level of prices deflates all macro and financial variables, such as the disposable income of households, financial and tangible wealth that determine consumption, profits that determine investment, as well as equity prices, to name only but a few. The demand for assets (money, bonds, equities and property) as well as the demand for goods and services is proportional to the price level. Thus, positive inflation pushes up the level of prices and raises the nominal demand for assets and goods and services changing the desired level of inventories of goods that firms wish to keep and hence production and employment. Third, inflation is a key variable in shaping the risk premia in financial markets, which play a vital role in the demand for the various assets (money, bonds and equities). It is through the widening of these risk premia that the current credit crisis has been reflected. Accordingly, the outlook for the entire economy crucially depends on the trajectory of future prices and inflation.