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Concept Version 5
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Using Monetary Policy to Target Inflation

Inflation targeting occurs when a central bank attempts to steer inflation towards a set number using monetary tools.

Learning Objective

  • Assess the use of inflation targets and goals in monetary policy


Key Points

    • Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.
    • If inflation appears to be above the target, the bank is likely to raise interest rates; if inflation appears to be below the target, the bank is likely to lower interest rates.
    • Increases in inflation, measured by the consumer price index (CPI), are not necessarily coupled to any factor internal to country's economy and strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.

Term

  • consumer price index

    A statistical estimate of the level of prices of goods and services bought for consumption purposes by households.


Full Text

Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools .

Fed Reserve Seal

The United States Federal Reserve uses a form of inflation targeting when coordinating its monetary policy.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples include:

  • if inflation appears to be above the target, the bank is likely to raise interest rates. This usually has the effect over time of cooling the economy and bringing down inflation;
  • if inflation appears to be below the target, the bank is likely to lower interest rates. This usually has the effect over time of accelerating the economy and raising inflation.

Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.

The United States Federal Reserve, the country's central bank, practices a version of inflation targeting. Instead of setting a specific number, the Fed sets a target range.

Criticisms of Inflation Targeting

Increases in inflation, measured by changes in the consumer price index (CPI), are not necessarily coupled to any factor internal to country's economy. Strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.

It has been argued that focusing on inflation may inhibit stable employment and exchange rates. Supporters of a nominal income target also criticize the tendency of inflation targeting to ignore output shocks by focusing solely on the price level. They argue that a nominal income target is a better goal.

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