Question

Which of the following is true regarding the target inflation rate? Instructions: You may select more than one answer. A. A positive target inflation rate increases the likelihood that firms will need to reduce nominal wages when the demand for labor falls. B. A positive target inflation rate is preferred because the country will be able to better avoid a liquidity trap. C. A positive target inflation rate increases the risk of deflation. D. A target inflation rate of zero is a good policy because this will keep prices stable.

Answer 1

These statements are true:

A. A positive target inflation rate increases the likelihood that firms will need to reduce nominal wages when the demand for labor falls.

Assuming that a positive interest rate means a rate over 0% ( i > 0 ), if a central bank has an inflation target higher than the previous rate, nominal costs will rise, including the costs of hiring, and if in conjunction to this, the demand for labor falls, nominal wages will be reduced, because workers are now not only more expensive but also less needed.

B. A positive target inflation rate is preferred because the country will be able to better avoid a liquidity trap.

A liquidity trap occurs when the prevailing nominal interest rate in the market is very low, for example 0% or even negative, and people prefer cash over deposits because the interest earned on those deposits is negligible.

A liquidity trap can be caused by deflation, or cause deflation, therefore, central banks should target a positive inflation rate. The most common method to do this is quantitative easing: the expansion of asset purchases by the central bank in order to increase the money supply, promote economic activity, and thus, increase inflation and interest rates, solving in this way the liquidity trap.