In a research paper, three IMF (International Monetary Fund) economists argued whether policymakers worldwide should aim for higher inflation rate in normal time, so that there is greater room for monetary policy when responding to shocks.
If inflation is high, nominal interest rates would also be high since high inflation makes people ask for high returns on their deposits, that pressure other interest rates as well.
"As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions," Olivier Blanchard, a co-author of the paper, said in an interview posted on the IMF website.
The advice came at a time when Indian central bank-- RBI-- is tweaking its monetary tools to control inflation that is already above the comfort zone at over 7 per cent. The paper 'Rethinking Macroeconomic Policy' is authored by Blanchard, Giovanni Dell'Ariccia, and Paolo Mauro.
According to him, the crisis showed that interest rates can actually hit the zero level, resulting in a "severe constraint on monetary policy that ties your hands during times of trouble".
In the wake of the financial meltdown, many developed nations including the US resorted to near-zero interest rate regime, as part of their efforts to ease the credit situation. Blanchard is a head of the Research Department. Dell’Ariccia is an Advisor in the Research Department and Mauro is a Division Chief in the Fiscal Affairs Department.
"Policy implications for next decade or two are that ... should economic growth recover rapidly, it should be used to reduce debt-to-GDP ratios substantially, rather than to finance expenditure increases or tax cuts," the paper noted.
The three economists said that in the worst-crisis scenario, policymakers have to watch many targets including the composition of output and the behaviour of asset prices, among others. Pointing out that the financial meltdown has exposed flaws in policy framework, the paper said low public debt in good times creates room to act forcefully when needed.
"Good plumbing, in terms of prudential regulation, and transparent data in the monetary, financial, and fiscal areas are critical to our economic system functioning well," it added.
