Our models have an underlying flaw that they fail to measure uncertainty and stochastic and exogenous shocks which have resulted in the forecasting errors...
Rational expectations modeling is also erroneous since we can’t expect everybody to understand the price and demand and supply dynamics in the market...
The assumption that individuals are rational and have full knowledge is not right and above that the uncertainty and stochastic errors make the modeling redundant and require forward and clear guidance to help manage investments...
It is the duty of the central bank to educate investors on its actions loud and clear with certainty which would help lower loss...
The forward guidance may save rate cuts and hikes since people would themselves control investment and spending if inflation crosses 2.5-3% or so...
Moreover they would increase demand and spending when prices are low and increase supply when prices are high which would help stabilise the price level, too...
If everybody would follow the central bank we could expect individual be rational and the expectations would be self full-filling...
The inflation and expectations affect the interest rate and expectations and the interest rate and expectations also affect the inflation and expectations or in short both reinforce each other which increase volatility.
The central bank manages the inflation and expectations by manipulating the interest rate when it shall adjust interest rate expectations in order to carve inflation expectations and stimulate spending and growth.
The central banks use interest rate to affect price level or inflation/disinflation/deflation expectations to increase spending, nonetheless they increase volatility by adjusting the borrowing cost or interest rate, lower borrowing cost reinforce lower prices and vice versa.
Though, the real interest rate remains same while adjusting interest rate since nominal interest rate equals real interest rate plus inflation it barely affects spending, but blocks correction through lower real interest rate and higher supply, moreover higher real interest rate also lower demand.
When the central banks could utilize the interest rate expectations to affect price expectations and spending they vaguely use interest rate to affect prices and demand/supply and spending.
During high inflation higher interest rate expectations could lower demand and price expectations and increase supply which could control prices whereas during low inflation lower interest rate expectations could increase demand and price expectations and also lower supply.
The central bank must alert the economy in advance on rate hikes and cuts before the actuals...
Higher interest rate expectations could lower demand and price expectations and increase supply and contain the price level and lower interest rate expectations could increase demand and price expectations and lower supply and contain the price level... which would help stabilise interest rate and expectations...
No comments:
Post a Comment