Financial Services: Inflation Targeting - Coursework Example

Financial Services Table of Contents Overview of Inflation Targeting 3 How inflation targeting operates in the UK 3 Benefits of inflation targeting 5Conclusion 8 References 9 Overview of Inflation Targeting Inflation targeting is a relatively new monetary-policy approach that is typified by a declared inflation target, an execution of monetary strategy that provides inflation forecast with a vital role, in addition to elevated level of transparency, precision and liability. This strategy was first established in New Zealand in the year 1990, and had been since been adopted and fruitful in more than twenty five developed as well as developing economies, in context of steadying both inflation plus real economy (Svensson, 2010). It is important for inflation targeting that the monetary authorities decide what price stability signifies in reality. Price stability has been extensively defined as a rate of inflation that is adequately small, so that consumers are not required to take it into consideration while making their daily decisions. A numerical value of inflation ranging from 0% to 3% tends to fulfill this condition. However, while some economists have spoken for a long-term inflation target of 0%, others have stated that such a low inflation target would result in inefficiency and rise in normal unemployment rate (Mishkin, 2001). This paper would discuss the chief elements of inflation targeting, how it operates in the United Kingdom and the benefits of inflation targeting. How inflation targeting operates in the UK Inflation targeting comprises of certain chief elements. These include the public declaration of medium-term inflation targets; institutional obligation to price stability as the fundamental objective of monetary policy; use of all encompassing information for creating policy tools; enhanced transparency of strategies related to monetary policy in context of communication of plans, goals as well as resolutions of monetary authorities; and, elevated liability of the central banks for accomplishing its inflation goals. Thus, it is apparently evident that inflation targeting is not merely a public declaration of inflation targets for the coming year, and incorporates the four other above mentioned elements as well (Mishkin, 2001). The UK economy performance following the application of inflation targeting has been exceptional. The magnitude of frequency variations of business-cycle has been till now the least in documented history of UK. Additionally, the trade-off between unemployment and inflation illustrates the utmost stability till date in the UK. Moreover, owing to the use of inflation targeting in the United Kingdom the existence of high inflation rates that were characteristic of the between the years 1972 and 1992 had completely disappeared. These outcomes can be considered as particularly strong and crucial for two grounds. First, the outcomes are extremely steady across series. Next, they have been resultant of comparatively plain statistical methods, which do not rely on possibly unacceptable fundamental suppositions (Benati, 2005). The crucial aspect of inflation targeting in the UK has been the selection of a point target. This approach has enabled simplicity and precision to the target. This had also assisted to affix the inflation anticipation of the private sector in a manner, which might not have been possible had the monetary authorities of the United Kingdom utilized a target band instead of point target inflation. This would have been particularly true that the target band be broad enough as it could lead to possible uncertainty as to the exact numeric value of inflation the central bank is striving to attain (Bean 2003). Another aspect of inflation targeting in UK that is highly appreciable is the focus that is given to accountability that came together with the resolution to hand over operational liability for monetary policy towards the Monetary Policy Committee. The fundamental channels in the UK inflation targeting are in the form of three tiers. First, the Monetary Policy Committee is liable to the Court of the Bank which monitors the Committee’s practices. Second, after the issuance of the Inflation Report, the members of the Monetary Policy Committee are queried regarding the rationale behind the interest rate choices by the apt Committee of Parliament. Finally, the Governor is supposed to inscribe an ‘Open Letter’ to the Chancellor, in case the inflation rate fluctuates greater than one percent from the set target. This letter is supposed to explain the reasons why the fluctuation had taken place, what measures are being taken by the Committee to reinstate the inflation rate to target and how the measures are in line with the overall economic policies of the UK government. This Open Letter had reinstated the pledge of the central bank towards accountability and it explains exactly why the inflation deviation had taken place, resulting in transparency and lucidity of the system (Bean, 2003; Lambert, 2005). Benefits of inflation targeting Inflation targeting has many benefits and is considered to be a vital medium-term tactic intended for monetary policy. Unlike exchange rate pegging, inflation targeting facilitates monetary policy to emphasis on domestic concerns and to react to instabilities in the national economy. On the other hand, unlike monetary targeting, the approach of inflation targeting is not reliant on the stable association amid inflation and money. Inflation targeting conversely utilizes all the accessible and obtainable information to identify the finest settings for the tools of monetary policy. Another crucial benefit of inflation targeting is that it is effortlessly comprehended by the public and is therefore extremely transparent (Mishkin, 2001). A precise inflation target in terms of numeric value enhances the liability of the central bank. As a result, inflation targeting is beneficial is lessening the probability that that the central bank would encounter the time-inconsistency issue. In general the main reason for the time-inconsistency problem is the political stress on the central bank to take up expansionary measures of monetary policy. The benefit of inflation targeting is that it directs the political discussion on what can be done in the long run to control inflation by means of monetary policy, instead of emphasizing on un-accomplishable issues like increasing rate of output, reducing unemployment and enhancing external competitiveness. Inflation targeting emphasizes on the requirement to ensure that monetary policies are transparent and frequent communications are held between the monetary authorities and the public. Central Banks in context of the policies of inflation targeting maintain regular interactions with the government in addition to making public speeches and publishing inflation reports. The maintenance of these aspects of inflation targeting has been vital for the success of this policy in the developed nations like the United Kingdom. On the whole, a central banks communications policy refers to the banks normal measures for interacting with the political bodies, the financial markets, in addition to the common public. Regular communication is directly related to the notion of transparency and has a lot of facets and numerous impetuses. The facets of communication that have been predominantly focused by central banks exercising inflation-targeting are the unrestricted declaration of policy goals, public conversation of the banks strategy framework and open disclosure of the central banks estimate or assessment of the economy in the public. Various conduits for communication are utilized by central banks across nations to explain the aspects of in inflation-targeting to the common public, players in the financial market as well as the politicians. The aspects that are regularly communicated include 1) the objectives and restrictions of monetary policy, as well as the underlying principle for the inflation targets; 2) the numerical values and the rationale of deciding on the inflation targets; 3) how the set inflation targets would be realized, considering the present economic circumstances and 4) rationale for any variation from the set targets. These communication activities as per the requirement of inflation targeting policy have enhanced private sector scheduling by lessening improbability concerning monetary policy, rate of interest and inflation (Djurovic-Todorovic & Djordjevic, 2008). One of the major advantages of inflation targeting is that the transparency of guidelines associated with it has the central bank inclined to be liable to the public. Determining an inflation target provides monetary policy an apparent anchor and enhances the answerability and precision of the monetary policy making bodies (Mishkin, 2001). From the economic point of view, an efficient inflation target can lessen the inflationary anticipation of the public, considering the fact that they believe that the targeted low inflation would be accomplished. This would then be likely visible in the salary demands of the public. When workers anticipate the inflation rate to remain low, they are likely to be prepared to agree to a slower increase in income. This, as a result, lessens the hazard of ‘cost-push inflation’ in the financial system. Conclusion Conclusively, it can be comprehended from the study that inflation targeting is monetary-policy approach, where the central bank along with the monetary authorities, set point inflation target and execute monetary strategies to control the inflation within the target. Moreover, the approach of inflation targeting ensures elevated level of transparency and precision and the monetary authorities frequently communicate not only with the government but also with the common public. The exercise of inflation targeting had helped stabilize the scenario of many countries and the United Kingdom is one of them. References Svensson, L. E. O., (2010). Inflation Targeting. National Bureau of Economic Research, Working Paper 16654. Mishkin, F. S., (2001). Inflation Targeting. Retrieved November 5, 2012, from http://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/01ENCYC.pdf#search=mishkin%20inflation%20targeting Djurovic-Todorovic, J., & Djordjevic, M., (2008). Features of Inflation Targeting as a Type of Monetary Strategy, Facta Universitatis, Vol.5, No1, pp. 39-49. Bean, C. (2003). Inflation Targeting: The UK Experience. Retrieved November 5, 2012, from http://www.bankofengland.co.uk/publications/Documents/speeches/2003/speech203.pdf Benati, L., (2005). The inflation-targeting framework from an historical perspective. Retrieved November 5, 2012, from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb050203.pdf Lambert, R. (2005). Inside the MPC, Retrieved November 5, 2012, from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb050105.pdf Read More