Inflation Targeting

Definition

Inflation targeting is a monetary policy framework in which a central bank publicly announces an explicit numerical target for the rate of inflation over a specific time horizon and then uses its policy instruments, such as interest rates, to achieve that target. The goal is to maintain price stability and anchor inflation expectations to the target level.

5 Must Know Facts For Your Next Test

1. Inflation targeting was first adopted by New Zealand in 1990 and has since been implemented by many other central banks around the world.
2. The central bank's commitment to the inflation target is intended to anchor inflation expectations, which can help reduce the costs of achieving and maintaining price stability.
3. Inflation targeting requires the central bank to regularly monitor and report on its progress towards the inflation target, which enhances transparency and accountability.
4. The choice of the inflation target level, usually between 2-3%, is a balance between maintaining low and stable inflation and avoiding the costs associated with deflation.
5. Inflation targeting has been generally successful in reducing and stabilizing inflation in countries that have adopted it as their monetary policy framework.

Review Questions

• Explain how inflation targeting works as a monetary policy framework and its key objectives.
  • Inflation targeting is a monetary policy framework where the central bank publicly announces a numerical target for the inflation rate, usually around 2-3%, and then uses its policy tools, such as adjusting interest rates, to achieve that target. The main objectives of inflation targeting are to maintain price stability, anchor inflation expectations, and promote sustainable economic growth. By committing to the inflation target and regularly reporting on progress, the central bank aims to enhance transparency and accountability in its monetary policy decisions.
• Describe the relationship between inflation targeting and inflation expectations, and how this can influence the effectiveness of monetary policy.
  • Inflation targeting is designed to influence inflation expectations, which can have a significant impact on actual inflation and the broader economy. When the central bank credibly commits to the inflation target, it helps to anchor the public's expectations about future inflation. This, in turn, can affect consumer and business decisions regarding spending, saving, and investment, as well as wage and price-setting behavior. If inflation expectations are well-anchored to the target, the central bank may be able to achieve its inflation objective with fewer disruptive changes to interest rates, making monetary policy more effective in promoting price stability and economic growth.
• Analyze the potential advantages and challenges of implementing an inflation targeting framework, particularly in the context of the historical picture of inflation discussed in Chapter 12.2.
  • Inflation targeting has several potential advantages, including enhanced transparency and accountability of monetary policy, better anchoring of inflation expectations, and improved credibility of the central bank. These factors can contribute to lower and more stable inflation, which is beneficial for economic growth and stability. However, implementing inflation targeting also presents some challenges, such as the difficulty in precisely controlling inflation due to various external factors, the potential trade-offs between inflation and other economic objectives like employment, and the need for the central bank to have sufficient policy independence and credibility. In the historical context of Chapter 12.2, the shift towards inflation targeting in many countries during the 1990s and 2000s was partly a response to the high and volatile inflation experienced in previous decades, and the desire to regain control over the inflationary process and anchor expectations more firmly.

Related terms

Monetary Policy: The actions taken by a central bank to influence the money supply and interest rates in an economy to achieve its economic policy objectives, such as price stability and full employment.

Inflation Expectations: The public's anticipation of the future rate of inflation, which can influence actual inflation through its impact on consumer and business spending and investment decisions.

Price Stability: A situation where the general price level in an economy is stable and there is low and predictable inflation, which helps to promote economic growth and well-being.