Gora DIOP, a graduate of IEDES at SORBONNE.
The objective of this theme is to present the gains as well as the challenges of coordinating monetary policy. However, initially, it seems appropriate to revisit inflation, or more precisely its origins, effects, and the policies often implemented to counter it. The goal is to show that inflation can have external origins, as a necessary condition for coordinating monetary policies is the existence of externalities. It will be referred to as imported inflation.
Indeed, a major advantage that can result from countries’ willingness to coordinate their policies is that cooperation can allow them to increase their overall output by implementing structural reform policies rather than fiscal policies. Therefore, if governments are non-cooperative, they will implement fewer structural reforms and more fiscal reforms.
I. Coordination or the courage to enact reforms
A. Causes of inflation
Inflation is an imbalance manifested by a general rise in prices and results in a decrease in the value of money, reducing its purchasing power. Temporary price spikes do not constitute inflation. For example, a merchant deciding to open on Sundays may increase prices due to a temporary monopoly.
Inflation is measured by the price index, indicating the current price level compared to a base level. Price indices may be unreliable, underestimating or overestimating inflation. Efforts are made by states to obtain more reliable measurement units.
It is important to differentiate between inflation, deflation, stagflation, and disinflation. Deflation is characterized by a slowdown in national production, increased unemployment, and rising prices. Stagflation combines production stagnation, high unemployment, and inflation. Disinflation involves a decrease in the inflation rate, with prices still rising at a slower pace.
A1. Expansion of the money supply (monetarist approach)
This is the oldest and most commonly accepted explanation. The money supply of a country includes all its monetary assets, such as coins, banknotes, and demand deposits. Initially, it was believed that the central bank alone caused the money supply expansion. However, it was later realized that secondary banks also contributed by granting excessive credits during economic prosperity.
Mr. FRIEDMAN explains inflation as an abnormally rapid increase in the money supply compared to production volume. This excess money leads to higher demand than available supply, resulting in price increases. The origin of inflation lies in inadequate control by economic and political authorities over the growth of the money supply.
The imbalance between supply and demand leads to consumer price increases when supply cannot meet demand. This demand surplus causes inflation only when it results from excessive money creation.
In this view, inflation is no longer solely linked to state policy but to the entire economic system.
This demand increase can result from:
– an increase in the money available for spending by agents (facilitated by surplus balance of payments);
– a change in national income distribution, savings, or increased consumption due to fiscal measures;
– increased exports resulting from strong global demand.
A2. Imported inflation
With increased international trade, it became apparent in the early 1970s that countries could not control inflationary pressures alone. Rising prices of imported raw materials and intermediate goods increase production costs for national companies, leading to price increases.
Several factors are beyond governments’ control. For example, the significant oil crisis of the 1970s saw imported oil prices multiply by 5 in 7 years.
Another factor is the introduction of floating exchange rates, causing moderately inflationary countries’ currencies to be regularly overvalued while high inflation countries had undervalued currencies, further increasing import costs.
With market deregulation, significant capital movements due to financial innovation are observed. This includes new products and universal banking activities, alongside increased economic activities.
Under the influence of these factors, it became more challenging for central banks to conduct monetary policy. Assessing the processes reveals both advantages and disadvantages.
Advantages include the ability for operators to earn interest on their balances based on market rates, reduced transaction costs, and access to a diverse range of services.
Disadvantages are associated with the impact of liberalization on the financial system, leading to sources of instability such as off-balance sheet operations, intensified competition among financial institutions, junk bonds, and international capital market developments.
Therefore, with market deregulation, significant capital movements occur. If a country decides to raise short-term rates to reduce inflation, it risks attracting capital seeking attractive returns. These funds may be used to distribute credit, contributing to the expansion of the money supply.
A3. Inflation through rising production costs
In this scenario, inflation results from a significant increase in costs, which can have various origins:
– an average wage increase exceeding productivity growth;
– increased financial charges due to high-interest rate policies;
– a rise in imported goods prices caused by foreign currency appreciation or price increases, leading to imported inflation.
B. Consequences of anti-inflation policies
Inflation benefits borrowers who repay in depreciating currency, while disinflation benefits lenders. In recent years, this has led to a shift of real and productive investments towards financial placements. Disinflation policies, characterized by monetary austerity, have led French economic agents to increase savings at the expense of business investment and household consumption.
E. Gains from international coordination of monetary policies
Since the most common cause of inflation is the expansion of the money supply, coordination is essential to implement reforms. Referring to the recent article by E. LEHMANN and E. TAUGOURDEAU in the Journal of Economic Integration, it is known that persistent unemployment is a pressing issue in the European Union. Therefore, it is crucial to consider the consequences of European Economic Integration (EEI) on employment levels.
EEI is often seen as a lack of autonomous monetary policy and a restriction on national fiscal policy instruments. The gains from undertaking labor market structural reforms may vary in the Economic and Monetary Union (EMU), depending on the type of reforms considered.
However, EEI extends beyond the EMU and the Amsterdam Treaty. It is necessary to identify the nature of externalities and their effects on policies conducted by non-cooperative governments. This perspective emphasizes that structural reforms are the only policies affecting output when governments cooperate.
F. Challenges of coordination
The presence of spillover effects or externalities between economies is a necessary but not sufficient condition for coordinating monetary policies. Partners must agree on objectives and actions to be taken collectively, with substantial and lasting benefits. Unfortunately, this is not always the case. Three types of obstacles to coordinated policies are identified:
– disagreements on objectives and economic operation;
– negotiation costs and constraints;
– attempts to renege and credibility issues.
The first obstacle relates to the uncertainty affecting economic decisions. Disagreements can arise in three areas: prioritized objectives, economic situation, and the effectiveness of various actions based on assumptions about instrument efficiency, structural characteristics of each economy, and international transmission mechanisms.
The second obstacle is associated with the constraints and costs of coordination, the difficulty of allocating actions and expected benefits, and immediate cost perceptions.
The third obstacle involves the temptation to cheat once an agreement is reached. This can be a problem for individual countries or collectively. Parties may be tempted to renege on commitments to benefit from both the common strategy and their individual strategy. While credibility benefits are expected to outweigh reneging, it is challenging for a government to commit on behalf of its successors.
Another challenge may lie in the issue of time inconsistency, unresolved at the national or local level, which may be shifted to bilateral or multilateral frameworks, given the assumption of economic agents’ rationality.
Conclusion
The primary virtue resulting from coordinating monetary policies is that states, as the involved actors, are no longer in a competitive situation. While international cooperation encompasses information exchange between countries on economic policy developments and intentions, international coordination of economic policies is more ambitious, aiming to maximize the welfare of multiple countries by positively exploiting interdependencies between their economies.
