Inflation Targetting

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Evaluating the monetary policy conducted by an inflation targeting central bank by comparing the actual values of inflation is surely inadequate: first no central bank has a complete control over inflation; second, in practice all that central banks care about stabilising economic activity.

Over the past half century, macroeconomic theory has undergone significant changes. More specifically, the importance of expectations has come to the forefront in economic theory to such an extent that monetary policy has been described as the ‘management of expectations’. Inevitably, this paradigm shift has influenced how monetary policy is carried out today. I believe that it is this evolution in economic theory that has brought about many major economies; the United Kingdom, Australia, Canada and Sweden to name a few, to adopt a new strategy for monetary policy known as inflation targeting. In this essay I hope to theoretically and intuitively explain the trade-off associated with inflation targeting and ultimately decide whether inflation targeting is a natural progression in monetary policy or whether it is detrimental to a country’s macroeconomic performance.  

It is true that a central bank can never have complete control over inflation. Shocks by their very nature are unexpected and therefore the monetary authority can only adjust policy accordingly in hindsight. For example the Bank of England can only change the base rate once a month hence there will always be a time difference between when the economy experiences the shock and when the Bank can react.  

In theory however, the central bank (CB) does have considerable control over inflation. To begin with, consider a temporary unexpected positive inflationary shock. (I chose to look at an inflationary shock because unlike productivity or demand shocks, the CB is faced with an undesirable trade-off that will be further discussed). Output will be below its natural level; inflation will be above its target which in...
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