Discuss Advantages and Disadvantages of Inflation Targeting, with Special References to the Case of the Uk.

Topics: Inflation, Monetary policy, Central bank Pages: 10 (3321 words) Published: November 9, 2012
Discuss advantages and disadvantages of inflation targeting, with special references to the case of the UK.

1.0 Introduction:
Prosperity, success and economic growth are largely perceived as created by free markets and private enterprise. However the need for government policy to promote economic growth as well as stability cannot be overlooked. Monetary policy has emerged as one of the most crucial government responsibilities this is due to a number of reasons. Firstly there is now a general agreement that low, stable inflation is important for growth and that ‘monetary policy is the most direct determinant of inflation’. Secondly monetary policy has ‘proven to be the most flexible instrument for achieving medium term stabilisation objectives’. The use of monetary policy by central banks meant inflation has been lower in most countries and aside from the current economic downturn, recessions have largely been absent. Since good economic performance today does not guarantee good economic performance in the future central banks develop strategies that provide not just good economic performance today but also stability and growth in the future. One of those strategies is inflation targeting. [1] 1.1 Definition:

The definition of inflation targeting is in itself part controversial. I will consider a few definitions given by the ECB, Ben Bernanke et al. and Mervyn King. The ECB defines inflation targeting as “a monetary policy strategy aimed at maintaining price stability by focusing on deviations in published inflation forecasts from an announced inflation target”.[2] Bernanke et al.’s (1999) definition of inflation targeting, “Inflation targeting is a framework for monetary policy characterised by the public announcement of official quantitative targets for the inflation rate over one or more time horizons.” He also states that ‘inflation targeting serves as a framework for monetary policy and not as a rule’. This is because treating inflation targeting as a policy rule could lead to poor economic outcomes for example Friedman and Kuttner (1996) state that it could lead to a highly unstable economy in the event of large supply side shocks. [3] Mervyn King defines an inflation targeting framework as constituting: • a precise numerical target for inflation in the medium term • a response to economic shocks in the short term. [4]

From above we can see that generally speaking inflation targeting is an economic policy in which the central bank estimates and makes public a target inflation rate. It then attempts to exercise actual inflation towards the target through the use of monetary tools. 1.2 Elements of Inflation Targeting:

According to Frederic Mishkin inflation targeting is a monetary policy that encompasses five main elements and they are as follows: 1) The public announcement of medium-long term numerical targets for inflation. 2) An institutional commitment to price stability as the primary goal of monetary policy. 3) An information inclusive strategy in which many variables are used for deciding the setting of policy instruments. 4) Increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives and decisions of the monetary authorities. 5) Increased accountability of the central bank for attaining its inflation objectives.[5] These elements will be explained in further detail later on in the paper.

2.0 Advantages of inflation targeting:

2.1 Purpose and economic rationale for inflation targeting:
When talking about inflation targeting and in fundamental nature price stability we need to understand what we mean by price stability. Alan Greenspan has provided the definition of price stability as a rate of inflation that is sufficiently low so that households and businesses do not have to take it into account in making everyday decisions. Operationally any inflation number between 0 and 3% seems to meet...
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