Inflation Targeting: Central Banks Should Not Go For It

A Project Report on

Inflation Targeting: Should Central Bank go for it?

Economic Environment and Policy

INFLATION TARGETING

Definition

Inflation targeting framework refers to a set of economic policies adopted by the central

bank wherein it announces a projected or "target" inflation rate and strives to achieve that

figure using measures like interest rate changes and other monetary tools.

Elements of Inflation Targeting[1]

· Announcement of an explicit quantitative inflation target or range for some period

of time.

· Central bank must show clearly and unambiguously that its most crucial aim is to

provide an environment with stable prices.

· Central bank should have powerful models to make inflation forecasts.

· The central bank must have a forward-looking operating procedure in which the

setting of policy instruments depends on the assessment of inflationary pressures

and where the inflation forecasts are used as the main intermediate target.

Prerequisites for Inflation Targeting[1]

· Central bank should be able to conduct monetary policy with a degree of

independence.

· Absence of another targeted variable such as wages, level of employment, or the

nominal exchange

· Existence of stable and predictable relationship between the monetary policy

instruments and inflation rate.

Issues with the implementation of Inflation Targeting

1. Time inconsistency situations

Time inconsistency situations may occur because the central bank would try to

reoptimize in the short term and lose sight of the long term goals. The bank may

start out with a particular policy and then keep changing its policy to suit some

short term requirements. Such a conduct wouldn’t have the desired effect. This

effect can be explained using a model for inflation targeting. [2]

2

p = pT-a(x-u)

p = inflation

pT = target inflation percentage

x= output gap (Y-Yn ) / Yn

u= fluctuations

a=l/ak

a= constant, k= measure of the cost of inflation fluctuation

l= measure of the cost of output fluctuation

Consider a case where the fluctuations, u=0. For a given value of ‘x’, the value of

p would change if the value of a changes. If the central bank continuously changes the

importance it attaches to its goal of achieving targeted inflation rate and maintaining zero

output gap, the value of a would vary and the achieved inflation rate would continuously

fluctuate thus causing inflation forecast errors

2. Volatility of the exchange rate

A study of the variability of exchange rate in countries who have adapted inflation

targeting shows that the though the variability decreased in the first 3 years of adoption of

the policy , the coefficient of variation has been huge when the overall period was

considered.(Ref. Table 1). Such huge depreciations of currency would increase the dollardenominated