Does the Price Gap Predict Inflation? : An Approach Based on the Theory of the Price Level
Author : Bae-Geun Kim
Despite the rapid expansion of liquidity in most countries since the 2000s, inflation has remained subdued for a considerable time. The Korean economy has also experienced a weak relation between money growth and inflation since the currency crisis. This raises the question of whether money growth leads to inflation with some time lag. This paper presents the possibility that the weak relation between the two is caused by a shift in the monetary policy regime, that is, from a monetary targeting regime to an inflation targeting regime.
In order to account for this, it is necessary to show how the price level is determined in the long-run depending on the monetary policy regime. This paper introduces a concept of the long-run equilibrium price level, and explains how the determination of the price level is affected by the policy regime. It turns out that the long-run equilibrium price level is determined by the money stock under the monetary targeting regime. As a result, the price gap, that is, the gap between the long-run equilibrium price level and the current price level, has a high predictability of future inflation. In contrast, under the inflation targeting regime, the long-run equilibrium price level is not determined by the money stock as money is supplied endogenously. Rather it is shown that the long-run equilibrium price level is pinned down by the interest rate. In this case, the price gap no longer predicts future inflation.
The results of this paper suggest that the relation between monetary developments and future inflation is more complex under the inflation targeting regime. Although money demand is stable over time, future portfolio adjustments can greatly affect the movements of the monetary aggregates and the price level.
JEL Classification Number : E31, E32, E52, E58
Keywords : Monetary Theory of the Price Level, Long-run Equilibrium Price Level, Price Gap,
Inflation