Inflation targeting

Definition

Inflation targeting is a monetary policy framework that aims to maintain price stability by setting a specific inflation rate as the goal for monetary authorities. This approach helps guide economic decisions by clearly communicating the targets to the public, which can influence expectations and behaviors in the economy. It connects closely with economic theories about how central banks should operate to achieve stability and growth, reflecting underlying principles of monetarism and modern economic thought.

5 Must Know Facts For Your Next Test

1. Inflation targeting was popularized in the 1990s, with New Zealand being one of the first countries to adopt this approach, influencing many others around the world.
2. The effectiveness of inflation targeting depends heavily on the credibility and transparency of the central bank in communicating its goals to the public.
3. Inflation targeting can help anchor inflation expectations, which is crucial for maintaining price stability over time.
4. This framework often involves a flexible approach that allows for consideration of other economic objectives like employment and growth, rather than focusing solely on inflation.
5. Critics argue that inflation targeting can sometimes lead to neglect of other important economic issues, such as financial stability or asset bubbles.

Review Questions

• How does inflation targeting influence central bank policies and public expectations regarding future inflation?
  • Inflation targeting provides a clear framework for central banks to communicate their goals, which helps shape public expectations about future inflation. By announcing specific targets, central banks can guide economic behavior, as businesses and consumers adjust their actions based on anticipated price stability. This alignment of expectations can enhance the effectiveness of monetary policy, making it easier for central banks to achieve their inflation goals.
• Evaluate the role of credibility in the success of inflation targeting as a monetary policy strategy.
  • Credibility is vital for the success of inflation targeting because it determines how effectively a central bank can influence expectations. If the public trusts that the central bank will adhere to its targets, they are more likely to adjust their behaviors in ways that support stable prices. Conversely, if there is skepticism about the central bank's commitment or capability to meet its targets, then expected inflation may rise, undermining the policy’s effectiveness and potentially leading to higher actual inflation.
• Assess how inflation targeting interacts with critiques of monetarism and influences new Keynesian economics.
  • Inflation targeting illustrates a blend of monetarist principles and new Keynesian ideas by emphasizing price stability while also acknowledging the importance of demand-side factors. Critics of monetarism argue that rigidly adhering to money supply controls can overlook important aspects of economic behavior and market imperfections. In contrast, new Keynesian economics suggests that incorporating adaptive expectations allows for more flexibility in addressing real-world complexities. Inflation targeting seeks to reconcile these perspectives by maintaining focus on inflation while also permitting adjustments based on broader economic conditions.

Related terms

Monetary Policy: The process by which a central bank manages the supply of money and interest rates to achieve specific economic objectives, including controlling inflation and stabilizing the currency.

Price Stability: A situation in which prices in an economy do not change significantly over time, often characterized by low and stable inflation rates that foster economic growth.

Central Bank Independence: The degree to which a country's central bank operates without political interference, allowing it to make decisions based on economic rather than political considerations.