Course Work on Inflation Targeting

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Middlebury College
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Course work
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Inflation targeting can be said to be the monetary policy strategy utilized by the central bank as a tool for maintaining stability in prices while boosting economic growth. Inflation is the rate at which the general price levels escalate rapidly causing the purchasing power of currency to decline. The Central Bank is tasked with the onus of limiting inflation and avoiding deflation with the primary objective being to maintain a smooth running economy.

Inflation has the effect of lowering the purchasing power of currency. If the inflation rate is 2%, the cost an item will be $1.02 in the next year. While commodities require additional funds to purchase, the inherent value of that money declines.

The central bank sets the inflation rate at a particular rate with the main aim being to maintaining price levels at a targeted level. Inflation targeting aims at averaging in future years regardless of the current level of inflation. Inflation targeting has the effect of making consumers believe that future prices will continue to rise thereby prompting them to purchase household goods and services in bulk today before the prices escalate. Germany and Switzerland Central Banks were among the first to embrace inflation targeting policies especially after the collapse of Bretton Woods International Monetary System. During this period, the U.S. dollar collapsed thereby causing affecting the currencies. The successful implementation of inflation targeting policies by countries such as Germany to avoid the 1920 hyperinflation, countries such as Germany adopted inflation-focused, and this made other countries such as Canada, England, Sweden, Australia and Japan to take similar policies.

The benchmark used for inflation targeting is typically a price index of a basket of consumer goods such as consumer price index (CPI). But why exactly does the central bank desire inflation? Well, inflation targeting is a policy tool advanced by the central bank which involves meeting present, publicly displayed targets for the annual rate of inflation. It goes without saying that a situation where prices increases would be curbed would be the most desirable effect. Instead of deflation, a weak and managed inflation rate would be most preferable. It is important to form the right economic climate in a situation where the prices are rapidly increasing, and thats where inflation targeting validates its significance. The Federal Reserve boosts economic growth through the addition of liquidity, credit, and employment in the economy. Together with the inflation target rates and calendar dates to be used as performance measures, inflation targeting policy may also have established steps that are to be taken depending on how much the actual inflation rates varies from the targeted level, such as cutting lending rates. One of the major concerns and objectives of the Federal Reserve involves maintaining inflation at a low level while establishing a stable growth in gross domestic product and low unemployment levels. High growth and demand outstrip supply, and when prices rise, inflation arises. Growth can be created in two ways. The Federal Reserve adopts an expansionary monetary policy with the aim of lowering interest rates. However, the Congress applies a discretionary fiscal policy which involves a series of tax cuts or increased government spending.

At the instance where the core inflation rate rises above the Feds inflation target of 2percent, the central bank is forced to adopt a contractionary monetary policy. Ideally, this action not only increases the interest rates but also leads to the reduction of money supply and moderate demand-pull inflation. Moreover, inflation levels of 1-2% on an annual basis are considered acceptable and desirable while inflation rates greater than 3% are usually undesirable since they have the potential of devaluing the currency. Inflation above the target has the effect of imposing economic costs such as uncertainty, loss of competitiveness as well as menu costs.

In the UK, the monetary policy committee (MPC) sets the monetary policy, and thus, the government cannot interfere with the monetary policy decisions. The MPC uses interest rates to achieve its mission. In the United States, the FED maintains the economic policies. Ideally, it is tasked to set a low inflation rate and maintain employment at full level. In an aim to prevent the economy from going into recession, the FED cuts interest rates. At the instance at which the inflation rate is above the targeted inflation rate, the MPC may increase interest rates which will consequently increase the borrowing costs and reduce the consumer spending and investment. The overall effect of this move is to slow the growth rate in aggregate demand as well as inflation. On the other hand, if the inflation rate is below the target and the economic growth rate is at its minimum, the MPC would consequently decrease the interest rates to stimulate the aggregate demand.




Inflation targeting




From the above graph, expectations are dependent on a regime characterized by inflation. The inflation rate at time five will only be at 1percent. In this case, the target prices will be historically dependent (Woodford, 2003). Thus, this validates new Keynesian models outcomes with regards to inflation targeting.

When the inflation rate rises to 3percent, households and firms expect future inflation of 2percent in the subsequent periods and raising interest rates has the effect of lowering the inflation reining in the economy while reducing the interest rates accelerates the economy and brings about inflation.





An inflation rate of above 2percent would prompt the central bank to increase base rates to reduce the mounting inflationary pressure. During a period of economic growth, wage increases are usually higher than inflation, and this contributes towards positive real wage growths.

Between the 1980s and early 1990s, the US experienced a walking inflation which reached a peak of 6.1percent. In the 1970s, the United States experienced a galloping inflation which was a result of wage-price controls which consequently lead to stagflation. Japans economy also experienced deflation during the period 1989s 1990s when the Bank of Japan raised the interest rates causing the demand housing demand to decline. There was a general decline in prices while business experienced limited expansion. The fiscal policies advanced by the government worsened the situation as it only doubled the debt levels without corresponding confidence in investment. Japan then became a victim of this liquidity trap. The effects of deflation are reflected in the mortgage prices. The decrease in house prices leads to homeowners losing equity as well as the home itself. The resultant effect is that investors wait for the housing market to recover and as this unfolds, demand deficiency results to the downward spiral of mortgage prices.

Most G7 central banks use an inflation target of 2% which applies to the core inflation rate. The standard eliminates the effect of food and energy prices since their prices are volatile and fluctuate a lot while monetary policy tools are slow-acting. It has been established that it takes approximately six to eighteen months before the interest rate change impacts the economy. The personal consumption expenditure price index is used by the Federal Reserve in measuring inflation. Additionally, the FED aims at establishing economic growth and maintaining unemployment rate at its lowest. Ideally, a GDP growth rate of about 2-3 percent is considered ideal while the favorable natural unemployment rate is set at 4.7-5.8 percent (

According to Britains Finance minister George Osborne, central banks from the Group of Seven economic powers are on the move to ensure adequate liquidity in financial markets aftershocks of Britains decision to leave the EU. The group of 7 (G7) consist of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. These countries have advanced economies as reported by International Monetary Fund as their wealth represents more than 64% of the net global wealth ($263 trillion). They are typical of having high net national wealth and a highly high human development index are the main requirements of being a member of this group.

Inflation targeting enables transparency. Monetary authorities who have sufficient credibility that people are confident that the target will be reached, households as well as companies will be in a position of planning ahead and negotiate wages by expecting low and stable inflation. If inflation target did not exist, people might have higher inflation expectations, and this may encourage workers to demand higher salaries and firms to put up prices. Thus, imposing inflation target makes it easier to keep inflation low. Moreover, inflation targeting sets the pace as it determines the expectation about inflation. Consequently, it makes the economy perform better since consumers are motivated to shop for more goods and services in anticipation of increased prices in future. The increased purchases spike the much-needed demand which consequently spurs economic growth. Additionally, inflation target is to promote investment given that consumers are encouraged to buy property sooner than later since the investments are likely to generate higher returns in future when their prices increase.

Essentially, to avoid a boom and bust in the economy cycle, the central bank adopts inflation targeting. High inflationary growth in the economy is usually unsustainable and more likely than not, it leads to recession. By incorporate an inflation target, boom and bust cycles are eliminated.

Inflation costs eradication. Setting inflation target helps avoid various economic costs such as uncertainty which has the effect of causing lower investment, loss in international competitiveness as well as the reduction in savings. Unlike other countries such as Canada, Australia, and New Zealand, the United States does not typically have an explicit target for inflation. By adopting inflation target policies, G7 countries will be in a position of having lower and more stable prices and growth. Setting inflation target brings about cost-push inflation which may cause a temporary blip in inflation. Maintaining a 2percent inflation rate would require the central bank to keep high-interest rates an action which would lead to a lower growth of the economy.

Inflation target has the potential of boosting economic growth, especially during the regular economic cycles. However, prolonged recession threatens the usefulness of inflation target. It is risky for the Central Bank to focus so much on low inflation while severe economic and social unemployment problems continue to persist in the economy. The majority of the hard assets are typically protected against inflation since commodities tend to appreciate during times of high inflation. Additionally, certain funds are created with the aim of helping investors to hedge against the negative inflationary effects. The best solution out of this situation would be adopting a dual target where the central bank gives an equal weighting to an inflation target and output gap target. Ensuring flexibility in the inflation target is important. Explicit goals for consumer prices may fail to prevent credit bubble and recession. However, it is advisable that focus is shifted to asset prices in determining economic policies.


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