Inflation Targeting - Coursework Example

Infltin trgeting [Nama of the School] of the Introduction The 1990s saw the introduction of explicit inflation targets for monetary policy in a number of countries such as Australia, New Zealand, Canada, the United Kingdom, Sweden, Finland, and Spain. Inflation targeting has been introduced as a way of further reducing inflation and to influence market expectations, after disappointment with monetary targeting (New Zealand and Canada) or fixed exchange rates (United Kingdom, Sweden, and Finland). In the following paper I will discuss inflation targeting as one of central bank's monteray policiy's to regulate stability in the country. First, I will introduce the notion of inflation targeting, then I will look at the literature review of inflation targeting as well as speak aboutunfavorable shocks that make influence the policy, ultimately I will drow on the conlclusion as wether inflation targeting has proved to be a successful strategy in many industrialized countries or that it was only due to the fact that central banks have not been hit by strong unfavorable shocks. Inflation targeting as a strategy of central banks Infltin trgeting is mnetry-plicy strtegy tht ws intrduced in New Zelnd in 1990, hs been very successful, nd hs nw been dpted by mre thn 20 industrilized nd nn- industrilized cuntries. It is chrcterized by (1) n nnunced numericl infltin trget, (2) n implementtin f mnetry plicy tht gives mjr rle t n infltin frecst nd hs been clled "infltin-frecst trgeting", (3) nd high degree f trnsprency nd ccuntbility. The numericl infltin trget is typiclly rund 2% t n nnul rte fr the cnsumer price index (CPI) r cre CPI; either in the frm f rnge, such s 1-3% in New Zelnd nd Cnd; pint trget with rnge, such s 2% pint trget with tlernce intervl f plus/minus ne percentge pints in Sweden; r pint trget withut ny explicit rnge, such s 2% in the U.K. nd 2.5% in Nrwy. (Mishkin, Eakins, 2006) The difference between these frms des nt seem t mtter in prctice: centrl bnk with trget rnge seems t im fr the middle f the rnge, nd the edges f the rnge re nrmlly interpreted s "sft edges," in the sense tht they d nt trigger discrete plicy chnges nd being just utside the rnge is nt cnsidered much different frm being just inside. The relation between inflation targets and central bank preferences has been thoroughly investigated. On one hand, there is a theoretical literature of Walsh (1995), Svensson (1997) that concludes that inflation targets can be used as a way of overcoming credibility problems because they can mimic optimal performance incentive contracts. On the other hand, there is an empirical literature (Bernanke et al. 1999), that looks whether inflation targets have been instrumental in reducing the policy-implied short-term trend rate of inflation. Broadly speaking, the evidence is that inflation targets have indeed brought about a change in policymaker's inflation preferences. Unlike the relation between inflation targets and central bank preferences, a relatively underexplored issue is how to translate inflation targets into short-term interest rates. This is the issue of how to map explicit "targets" for monetary policy into monetary policy instruments, or how to implement an inflation-targeting framework. An exception is an important contribution by Svensson (1997). Svensson shows that because of lags in the transmission process of short-term interest rates to inflation, inflation targeting implies inflation forecast targeting. In his analysis, the central bank's forecast becomes an explicit intermediate target and its optimal reaction function has the same form as the Taylor rule (1999). Bullard and Schaling (2001) augment the Svensson model with regime switching in productivity and calculate the optimal monetary policy rule in the altered environment. They find that a rule that incorporates leading indicators about regimes significantly outperforms the Taylor rule. They use this result to comment on the new economy events of the 1990s and the stagflation events of the 1970s. In prctice, infltin trgeting is never "strict" infltin trgeting but lwys "flexible" infltin trgeting, in the sense tht ll infltin-trgeting centrl bnks (centrl bnk is used s the generic nme fr mnetry uthrity) im nt nly t stbilizing infltin rund the infltin trget but ls put sme weight n stbilizing the rel ecnmy, fr instnce, implicitly r explicitly stbilizing mesure f resurce utiliztin such s the utput gp between ctul utput nd "ptentil" utput. Thus, the "trget vribles" f the centrl bnk include nt nly infltin but ther vribles s well, such s the utput gp. The bjectives under flexible infltin trgeting seems well pprximted by qudrtic lss functin cnsisting f the sum f the squre f infltin devitins frm trget nd weight times the squre f the utput gp, nd pssible ls weight times the squre f instrument-rte chnges (the lst prt crrespnding t preference fr interest-rte smthing). (The instrument rte is the shrt nminl interest rte tht the centrl bnk sets t implement mnetry plicy.) Hwever, fr new infltin-trgeting regimes, where the estblishment f "credibility" is pririty, stbilizing the rel ecnmy prbbly hs lwer weight thn when credibility hs been estblished (mre n credibility belw). (Mishkin, Eakin, 2006) Becuse there is lg between mnetry-plicy ctins (such n instrument-rte chnge) nd its impct n the centrl bnk's trget vribles, mnetry plicy is mre effective if it is guided by frecsts. The implementtin f infltin trgeting therefre gives min rle t frecsts f infltin nd ther trget vribles. It cn be described s frecst trgeting, tht is, setting the instrument rte (mre precisely deciding n n instrument-rte pth) such tht the frecsts f the trget vribles cnditinl n tht instrument-rte pth "lk gd," where "lk gd" fr instnce mens tht the infltin frecst pprches the infltin trget nd the utput-gp frecst pprches zer t n pprprite pce. (Mishkin, Eakin, 2006) Infltin trgeting is chrcterized by high degree f trnsprency. Typiclly, n infltin- trgeting centrl bnk publishes regulr mnetry-plicy reprt which includes the bnk's frecst f infltin nd ther vribles, summry f its nlysis behind the frecsts, nd mtivtin fr its plicy decisins. Sme infltin-trgeting centrl bnks ls prvide sme infrmtin, r even frecsts, f its likely future plicy decisins. This high degree f trnsprency is exceptinl reltive t the histry f centrl bnking. Trditinlly, centrl-bnk bjectives, delibertins, nd even plicy decisins hve been subject t cnsiderble secrecy. It is difficult t find ny resns fr tht secrecy beynd centrl bnkers' desire nt t be subject t public scrutiny (including scrutiny nd pssible pressure frm gvernments r legisltive bdies). The current emphsis n trnsprency is bsed n the insight tht mnetry plicy t very lrge extent is "mngement f expecttins." Mnetry plicy hs n impct n the ecnmy mstly thrugh the privte-sectr expecttins tht current mnetry-plicy ctins nd nnuncements give rise t. The level f the instrument rte fr the next few weeks mtter very little t mst ecnmic gents. Wht mtters is the expecttins f future instrument settings, which expecttins ffect lnger interest rtes tht d mtter fr ecnmic decisins nd ctivity. (Bain, Howells, 2003) S fr, during the ne-nd--hlf decdes since its inceptin, infltin trgeting hs been cnsiderble success, mesured in the stbility f infltin nd the stbility f the rel ecnmy. There is n evidence tht infltin trgeting hs been detrimentl t grwth, prductivity, emplyment, r ther mesures f ecnmic perfrmnce. (Rger, Sctt, Stne 2005) The success is bth bslute nd reltive t lterntive mnetry-plicy strtegies, such s exchnge-rte trgeting r mney-grwth trgeting. N cuntry hs s fr bndned infltin trgeting fter dpting it, r even expressed ny regrets. Fr bth industril nd nnindustril cuntries, infltin trgeting hs prved t be mst flexible nd resilient mnetry-plicy regime nd hs succeeded in surviving number f lrge shcks nd disturbnces. (Rger, Sctt, Stne 2005) lng list f nnindustril cuntries is nw sking the Interntinl Mnetry Fund fr ssistnce in intrducing infltin trgeting.1 lthugh infltin trgeting hs been n unqulified success in ll the smll- nd medium-sized industril cuntries tht hve intrduced it, the U.S., the Eur re, nd Jpn hve nt yet dpted ll the explicit chrcteristics f infltin trgeting, but they re ll mving in tht directin. (Svenssn, Lrs, 2006) Reservtins ginst infltin trgeting hve minly suggested tht it might give t much weight n infltin stbiliztin t the detriment f the stbility f the rel ecnmy r ther pssible mnetry-plicy bjectives; the fct tht rel-wrld infltin trgeting is flexible rther thn strict nd the empiricl success f infltin trgeting in the cuntries where it hs been implemented seems t cntrdict thse reservtins. pssible lterntive t infltin trgeting is mney-grwth trgeting, where the centrl bnk hs n explicit trget fr the grwth f the mney supply. (Wdfrd, Michel 2005) Mney-grwth trgeting hs been tried in severl cuntries but been bndned, since prcticl experiences hve cnsistently shwn tht the reltin between mney grwth nd infltin is t unstble nd unrelible fr mney-grwth trgeting t prvide successful infltin stbiliztin. lthugh Germny's Bundesbnk pid lip service t mney-grwth trgeting fr mny yers, it ften delibertely missed its mney-grwth trget in rder t chieve its infltin trget nd is therefre rgubly better described s n implicit infltin trgeter. Mny smll nd medium-sized cuntries hve tried exchnge-rte trgeting in the frm f fixed exchnge rte, tht is, fixing its exchnge rte reltive t center cuntry with independent mnetry plicy. (Wdfrd, Michel 2005) Fr severl resns, including incresed interntinl cpitl flws nd difficulties defending misligned fixed exchnge rtes ginst specultive ttcks, fixed exchnge rtes hve becme less vible nd less successful in stbilizing infltin. This hs led mny cuntries t insted pursue infltin trgeting with flexible exchnge rtes. (Wdfrd, Michel 2005) current much-debted issue cncerning the further develpment f infltin trgeting is the pprprite ssumptin but the instrument-rte pth tht underlies the frecsts f infltin nd ther trget vribles nd the infrmtin prvided but future plicy ctins. (Svenssn, Lrs, 2006) Trditinlly, infltin trgeting centrl bnks hve ssumed cnstnt interest rte underlying its infltin frecsts, with the implictin tht cnstnt-interest-rte infltin frecsts tht vershts (undershts) the infltin trget t sme hrizn such s tw yers indictes tht the instrument rte needs t incresed (decresed). Incresingly, centrl bnks hve becme wre f number f serius prblems with the ssumptin f cnstnt interest rtes. These prblems include tht the ssumptin my ften be unrelistic nd therefre imply bised frecsts, imply either explsive r indeterminte behvir f stndrd mdels f the trnsmissin mechnism f mnetry plicy, nd t clser scrutiny be shwn t cmbine incnsistent inputs in the frecsting prcess (such s sme inputs such s sset prices tht re cnditinl n mrket expecttins f future interest rtes rther thn cnstnt interest rtes) nd therefre prduce incnsistent nd difficult-t-interpret frecsts. Sme centrl bnks hve mved t n instrument-rte ssumptin equl t mrket expecttins t sme recent dte f future interest rtes s they cn be extrcted frm the yield curve. (Svenssn, Lrs, 2006) This reduces the number f prblems mentined bve but des nt eliminte them. Fr instnce, the centrl bnk my hve view but the pprprite future interest-rte pth tht differs frm the mrket's view. few centrl bnks (ntbly in New Zelnd, Nrwy, nd Sweden (the lst prbbly within the next few mnths)) hve mved t deciding n nd nnuncing n ptiml instrument-rte pth, which slves ll the bve prblems, is the mst cnsistent wy f implementing infltin trgeting, nd prvides the best infrmtin fr the privte sectr. (Rger, Sctt, Stne 2005). The prctice f deciding n nd nnuncing ptiml instrument-rte pths is nw likely t be grdully dpted by ther centrl bnks in ther cuntries, in spite f being cnsidered mre r less impssible, r even dngerus, nly few yers g. (Svenssn, Lrs, 2006) nther issue is whether flexible infltin trgeting shuld eventully be trnsfrmed int flexible price-level trgeting. Infltin trgeting s prcticed implies tht pst devitins f infltin frm trget re nt undne. This intrduces unit rt in the price level nd mkes the price level nn-sttinry. Tht is, the cnditinl vrince f the future price level increses withut bund with the hrizn. In spite f this, infltin trgeting with lw infltin rte is referred t s "price stbility." (Bain, Howells 2003) n lterntive mnetry-plicy regime wuld be "price-level trgeting," where the bjective is t stbilize the price level rund price-level trget. Tht price-level trget need nt be cnstnt but culd fllw deterministic pth crrespnding t stedy infltin f 2%, fr instnce. (Bain, Howells 2003) Stbility f the price level rund such price-level trget wuld imply tht the price level becmes trend sttinry, tht is, the cnditinl vrince f the price level becmes cnstnt nd independent f the hrizn. ne benefit f this cmpred t infltin trgeting is tht lng-run uncertinty but the price level is smller. nther benefit is tht, if the price level flls belw credible price-level trget, infltin expecttins wuld rise nd reduce the rel interest even if the nminl interest rte is unchnged. The reduced rel interest rte wuld stimulte the ecnmy nd bring the price level bck t the trget. Thus, price-level trgeting my imply sme utmtic stbiliztin. This my be highly desirble, especilly in situtins when the zer lwer bund n nminl interest rtes is binding, the nminl interest rte cnnt be further reduced, nd the ecnmy is in liquidity trp, s hs been the cse fr severl yers until recently in Jpn. Whether price-level trgeting wuld hve ny negtive effects n the rel ecnmy remins tpic fr current debte nd reserch. (Bain, Howells 2003) Inflation targeting and unfavourable shocks Inflation targeting policies in small economies is oftentimes subject to severe shocks. The combined adverse financial and terms of trade shocks suffered by Australia, Chile Israel, and New Zealand, for example, led to major change rate devaluation in these countries and thus significantly tested the attainment of their inflation targets. They weathered this storm successfully, by recoiding little pass-through from devaluation to inflation. The 1999-2000 oil price shock represented the second test for oil-importing inflation targeters, including the countries mentioned above as well as Brazil, the Czech Republic, and Poland. Significant increases in imported inflation - through both energy prices and exchange rate devaluation - could put these countries' targets in jeopardy. The effects of the oil shock on core inflation appear to have been minor, however, and only temporary and modest increases in headline inflation have been observed. Conclusions This paper has provided discussion on whether monetary performance is improved by inflation targeting for countries that have adopted inflation targeting and for those who are planning or use this policy in their central bank's strategies to regulate interest rates. Hence inflation targeting seems to be the natural monetary-regime choice for emerging-market economies who aim at improving their monetary policy efficiency under adequate fiscal and institutional conditions. Not surprisingly, a large number of developing countries are currently planning adoption of inflation targeting in the near future. References: 1. Bernanke, Ben, Thomas Laubach, Frederick Mishkin, and Adam Posen (1999). "Inflation Targeting--Lessons From the International Experience." Princeton University Press. 2. Bullard, James, and Eric Schaling (2001). "New Economy: New Policy Rules." Quarterly Review Federal Reserve Bank of St. Louis 83, 57-66. 3. Mishkin F. and Eakins S., 2006. The Economics of Money, Banking, and Financial Markets. Addison-Wesley. 7 th ed. ISBN: 0321-37312-X. (ME2) 4. Infltin Trgets," IMF WP/05/163, Interntinl Mnetry Fund, www.imf.rg 5. Rger, Sctt, nd Mrk Stne (2005). "n Trget The Interntinl Experience with chieving 6. Bain, K. and P. Howells (2003). Monetary Economics: Policy and its Theoretical Basis. Palgrave MacMillan. 7. Svensson, Lars (1997). "Optimal Inflation Targets, 'Conservative' Central Banks and Linear Inflation Contracts." American Economic Review 87, 98-111. 8. Svenssn, Lrs E.., 2002, "Mnetry Plicy nd Rel Stbiliztin," in Rethinking Stbiliztin Plicy, Sympsium Spnsred by the Federl Reserve Bnk f Knss City, Federl Reserve Bnk fr Knss City, Knss City, M, 261-312, www.kc.frb.rg 9. Svenssn, Lrs E.., 2006, "ptiml Infltin Trgeting: Further Develpments f Infltin 10. Taylor, John, editor (1999). "Monetary Policy Rules," University of Chicago Press. 11. Walsh, Carl (1995). "Optimal Contracts for Central Bankers." American Economic Review 85, 150-167. www.princetn.edu/svenssn. 12. Wdfrd, Michel (2005). "Centrl-Bnk Cmmunictin nd Plicy Effectiveness," in The Greenspn Er: Lessns fr the Future - Sympsium Spnsred by the Federl Reserve Bnk f Knss City, Federl Reserve Bnk fr Knss City, Knss City, M, 399-474, www.kc.frb.rg Read More