2.3.2.4 Inflation Targeting Rule
Inflation targeting has been adopted as the framework for
monetary policy in a number of countries over the past decade. The existing
body of literature into this area shows that during the 1990's, New Zealand,
Canada, the UK, Sweden and Australia have shifted to that policy regime
(Svensson, 1998). In the general sense, under the inflation target rule, the
Central Bank would determine a target for the inflation rate (usually a low
one) and then adjust the money supply when the actual inflation deviates from
the target (Mankiw, 2000).
Several sources of literature in the area of monetary policy
show that the most important interest of any Central Bank is the desire for
price stability. One of the main reasons for that is simply that a key
principle for monetary policy is that price stability is a means to an end: it
promotes sustainable economic growth (Mishkin and Posen, 1997). In all of this,
Mishkin and Posen argued that a goal of price stability requires that monetary
policy be oriented beyond the horizon of its immediate impact on inflation and
the economy.
Mathematically speaking, Svensson (1999) defines inflation
targeting as an equation where target variables are involved. More
specifically, in inflation targeting, the target variable is inflation in the
loss function.
The equation can be expressed as follows:
Lt = ½ [(Ït -
Ï*) 2 + ëYt2]
Where Ït represents inflation in period t,
Ï* is the inflation targeting, Yt is the output gap
and ë is the relative weight on output-gap stabilization.
When ë = 0 this means that only inflation enters the
equation, the loss function is called strict inflation targeting whereas the
case when ë > 0 and the output gap enters the loss function is called
flexible inflation targeting. In most studies that have concentrated on
explaining the implementation of inflation targeting it has been shown that to
set the inflation target too low is risky because there is the possibility of
driving the economy into deflation with price levels falling unrealistically.
On the other hand, there is also the risk of allowing the start of an upward
spiral in inflation expectations and inflation.
Mankiw (2000) shows that in all countries that have adopted
inflation targeting, Central Banks are left with a fair amount of discretion.
Inflation targets are usually set as a range rather than a particular number.
The same author pursues the argument that the Central Bank is sometimes allowed
to adjust their targets for inflation, at least temporarily, if some exogenous
event (such as an easily identified supply shock) pushes inflation outside of
the range that was previously announced.
It is also important to note that there are certain
discussions which debate whether inflation targeting is a monetary policy rule
or not. Indeed, while Svensson regards inflation targeting as a monetary policy
rule, Bernanke and Mishkin (1997) and King (2003) show that inflation targeting
in practice is not a rule but it is a framework for monetary policy. This is
because, technically inflation targeting does not provide simple and mechanical
operating answers to the Central Bank.
According to the above authors, inflation-targeting allows the
Central Bank use all related information and structural economic model's to
decide their monetary policy and achieve their targets. Like this, the
inflation targeting should be taken as a framework for monetary policy.
The targeting of inflation has many important advantages in
principle as well as in practice. Mankiw (2000) explains that setting the
inflation target has a political advantage that is easy to explain to the
public. This is because when a Central Bank has announced an inflation target,
the public can more easily judge whether the Central Bank is meeting that
target. It therefore increases the transparency of monetary policy and, by
doing so, makes Central Bankers more accountable for their actions.
Considering the above advantages of inflation targeting, it is
well recognized that the success of inflation targeting cannot only be the duty
of the Central Bank: relevant fiscal policy and appropriated monitoring of the
financial sector are essential to its success.
However, apart from the success, inflation targeting also has
some disadvantages. Mishkin states these as follows:
«Because of the uncertain effects of monetary policy on
inflation, monetary authorities cannot easily control inflation» (Mishkin,
1997: 14). He supports this statement further by proposing that «it is far
harder for policymakers to hit an inflation target with precision than it is
for them to fix the exchange rate or achieve a monetary aggregate target»
(Mishkin, 1997: 14).
Another negative side of inflation targeting quoted is that
time delay of the effect of monetary policy on inflation are very long (the
estimates are in excess of about two years in industrialized countries). Thus,
in such case much time must pass before a country can evaluate the success of
monetary policy in achieving its inflation targets. Mishkin also proposes that
this problem does not arise with either a fixed exchange rate regime or a
monetary aggregate target.
More generally, evidence from different countries has shown
that inflation targeting can be used as a successful approach for gradual
disinflation. Consequently, the Central Banks of many countries now practice
inflation targeting, but allow themselves a little discretion.
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