1.1 Background of the Study:
In almost all countries, monetary authority is governed by a central bank. In some countries, it is called federal reserve or reserve bank. Other countries like Andorra, Monaco and North Korea do not have a central bank due to various reasons. The central bank has always been responsible in managing the nation's money supply or its monetary policy through managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during financial crisis. In the past years, central banks in industrialized countries have made great pace in the regulation of monetary policy.
The Bangko Sentral ng Pilipinas or BSP is the central bank of the Republic of the Philippines. It was established on July 3, 1993 which it took over from the Central Bank of Philippines or CBP. The BSP enjoys fiscal and administrative autonomy from the national government in the pursuit of its mandated responsibilities. And because the central bank is the one implementing monetary policy, which they discuss in detailed, the primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a balanced and sustainable economic growth. In order for the BSP to better achieve this objective, the inflation targeting framework for monetary policy was adopted in January 2002 after the monetary aggregate targeting framework.
Under the monetary aggregate targeting, the BSP fixes money growth so as to minimize expected inflation. However, under the current framework, BSP sets monetary policy so that price level is not just zero in expectation but is also zero regardless of latter shocks (Gochoco-Bautista, 2001). The inflation rate of a country has always been one of the most significant economic indicators. It indicates how well the economy is doing and how well the economy is going to do in the future. According to the Department of Economic Research of Bangko Sentral ng Pilipinas (BSP), the BSP itself followed the monetary aggregate targeting approach to monetary policy in the past. This approach is based on the assumption that there is a stable and predictable relationship of money and output and inflation. In one of the media archives of the BSP entitled “European Economists: High Marks to BSP for Clear and Comprehensive Inflation Report” in June 27, 2003, it stated that the BSP shifted its monetary policy framework from monetary aggregate targeting to inflation targeting only in January 2002. According also to the article, the BSP received positive feedback from various institutions like the Bank of England and the International Monetary Fund on its successful shift to inflation targeting since then. The framework was changed because BSP wanted to address the fact that aggregate targeting did not account for the long-run effects of monetary policy in the economy. The Department of Economic Research of BSP defined inflation targeting as an approach that focuses mainly on achieving price stability as the ultimate objective of monetary policy. It involves the announcement of an explicit inflation target that the central bank promises to achieve over a given time period. The target inflation rate is set and announced jointly by the BSP and the government through an inter-agency body. The Philippines joined a long list of inflation targeters such as Australia, Canada, Finland, Sweden, New Zealand, the United Kingdom, Israel, Brazil, Chile and Thailand, which have moved from high inflation to low inflation following the successful implementation of inflation targeting in their countries. The BSP, like other central banks, recognized the important features of inflation targeting. These are: * simple framework which can, therefore, be easily understood by the public; * allows greater focus on the goal of price stability, which is the primary mandate of the BSP; * forward-looking and recognizes that...