Inflation Targeting in South Africa

Topics: Inflation, Monetary policy, Central bank Pages: 34 (10061 words) Published: May 14, 2012
Inflation targeting

Inflation targeting is a policy aimed at obtaining a stable, positive and low rate of inflation, set as a point or a range of values .The evaluation of whether this policy can be better than price level targeting has been the subject of many studies (Citu, 2002, see below) . Finding which of the two is better implies stating which of the two can be characterized by lower variability of inflation , interest rates and output , and which can be more effectively monitored.

Choosing whether to target a specific value for inflation,i.e.,a point or a range of values,specifying the time horizon, evaluating inflation against an appropriate index , choosing whether to target inflation only or exchange rates and money supply, too, are some of the factors differentiating the inflation targeting framework of one country from that of another.

The key issues in designing an inflation targeting framework are:

definition of the target (point,range)
specification of the time horizon
the use of escape clauses
- credibility and involvement of the central institution - effect of the target on output

This paper covers these aspects one by one, also mentioning some questions of interest, as underlying inflation measurement; the writing about these issues will preceded and ended by two discussions currently of relevance: whether price level targeting or inflation targeting is preferable and results obtained by countries adopting an inflation targeting policy .

Price level targeting or inflation targeting ?

The main difference between inflation targeting and price level targeting , and that on which any comparison between the two is based, is that inflation targeting is a forward- looking policy , where “bygones are let to be bygones”.This means that any breach in the inflation target is not compensated, but the central bank tries to bring inflation back to previous levels ,and the central bank is worried only about the future path of inflation. On the contrary, when a certain level of prices is targeted , occasional breaches are to be immediately reversed by tightening monetary policy . Florin Citu, in his “ Review of the literature on the comparison of price level targeting and inflation targeting”(2002) looks at different models of price level and inflation targeting policies, grouping them as “price level targeting in models with output persistence” and “ price -level targeting with forward –looking price setting behaviour”. Two important representatives of the models are, respectively, Svennsson (1996) and Vestin (2002). Svensson,with his paper “Price level targeting vs. inflation targeting : a free lunch?”(1996), questions which of the two regimes could present better trade off between inflation and output variability. To facilitate comparison, he makes two main assumptions :

- that rules examined are endogeneous decision rules, i.e. , rules that result when “the society assigns an inflation target or a price level target to the central bank acting under discretion”, i.e. , when decision rules are formulated within a principal – agent relationship between society (principal ) and the central bank (agent ) -output persistence , which means that present output is explained in part by last period’s level of output.A moderate level of persistence in output will be needed for results on to be obtained.

As Citu (2002) asserts ,Svennsson (1996) uses a framework where Phillips curve enters the central bank’s loss function.

The Phillips curve , which expresses an inverse relation between inflation and unemployment , is adopted by Svennsson (1996) in the “new classical” version, where the only reason for which actual real GDP should deviate from the natural rate is because of incorrect expectations of what should happen in the future , while in the classical version of the Phillips curve the failure in attaining correct expectations about inflation is due...
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