Costs of discretion
2009-12-18 · Original WordPress address
In the previous post, I argued upping the inflation target would have no impact on unemployment and it would risk unanchoring inflation expectations. If expectations became unanchored we would be trading off a permanent increase in expectations for a temporary decrease in unemployment.
Assume we gave half of those currently unemployed a job, output would rise by about 5%. Without retargeting, I'm guessing it'll take 5 years for unemployment to get below 5% (unemployment has a two-year half life). So we're getting about 13% of GDP by retargeting.
The costs of 10% of inflation are estimated between 1% and 5% of GDP per year. Woodford estimates that under a discretionary policy, inflation would be about 10% (I'm looking at figure 7.1 in his textbook). Discretion isn't really permanent, its just really hard for the Fed to get expectations reanchored. Suppose x is the number of years of unanchoredness and so its the number of years we'd have 10% inflation.
How big can x be and still make retargeting cost effective? Using a low-end estimate of cost of inflation of 1%, x is 17 years. Using a high estimate of 5%, x is 2 years.