Economic Policies of Great Britain: Inflation Targeting - Research Paper Example

Introduction The British economy is the 5th largest in the world in 2006. The government controls fiscal and monetary policy to ensure sustainable growth. The Bank of England is the central bank in Britain and works with the government in formulating monetary policy strategies that regulate the economy. In early 1970s the government controlled monetary policy by regulating banks lending rates. This in turn reduces supply in the economy as individuals use these credits for investment. Low supply pushes prices up and leads to unemployment and wage reduction. The process is cyclical unless equilibrium is achieved. The government later abandoned this strategy and concentrated on regulating money supply (Bank of England, 2000-10). This ensures only the amount required is in circulation so as to stabilize prices and curb inflation. The monetary policy is only effective on short- run hence the need for long term strategies that can take of future inflation effects although some strategy should be used to deal with other variables. The objective of monetary and fiscal policies in Britain is to stabilize prices but this is hindered by other factors which cause inflation in the long-run. According to Bernanke et al (1999), a low stable inflation is important for market driven growth. Monetary policy is preferred to fiscal policy as it is flexible and easy to adjust. Monetary policies are at the discretion of politicians who manoeuvre them to their advantage. A chancellor may decide to create inflation so as to stimulate the economy and increase output and reduce unemployment but the long run effects of this decision is destabilization of the economy. Central banks also sometimes increase interest rates at their discretion leading to dire consequences. To avoid such undisciplined approaches and maintain a considerable rate of inflation, countries including U.K adopted a constrained monetary policy framework whereby they set target for inflation rate. It is then communicated to public for transparency. This paper is a critique of Britain inflation targeting. Inflation Targeting Bernanke et al (1999) defines inflation targeting as a framework for monetary policy which is characterized by public communication of the target. Inflation targets are founded on the basis that even moderate inflation rates are harmful to the economy and that price stability is the main goal of monetary policy. This enables policy maker to commit themselves to the objectives of controlling inflation in advance. At first inflation targeting was used by the Bank of England to criticize monetary policy strategies by the government that were discretionary. The bank used to communicate its inflation expectations to the public through publications to boost their confidence (Truman, 2003).This helped to restrict undisciplined approaches by the chancellor and make him accountable. If he wanted to stimulate the economy by creating inflation he had to think of the long-run effects of the strategy which would make the policy incredible not effective in future as it has negative consequence. The government used monetary policy to deal with output and employment. Without restrictions in price and quantity, the effects of stimulating output or employment are countered by increases in wages and unemployment in the long run hence making the policy not to be credible (Gavin, 2004) The public can then lose confidence in the monetary strategies by government and ignore any stimulus injected in economy. In 1992 after recession, the government decided to incorporate inflation targets as a nominal anchor of monetary policy. It also wanted to restore monetary policy credibility which has been lost during the foreign exchange crisis (Bernanke et al. 1999). The role of exchequer was to control the instruments of monetary policy and the Bank of England acted as forecaster of inflation and also assessing effectiveness of the target. The bank also communicated to the public through publications on the commitment to price stability of the monetary policy strategy. The inflation target was regarded as the annual change in retail price index excluding payment of interest on mortgages (RPIX). The price index also excluded the first round effects of indirect taxes but included food and energy prices (National statistics, 2010). It was a target range of 1%-4% which was later revised to 2.5% or less and would last as long as the life of current parliament (Bernanke et al. 1999).The monetary policy remained flexible to enable the government to deal with short-run macroeconomic variables. The chancellor and bank governor had frequent meetings to discuss interest rates and how they are fairing in containing inflation. The work of governor was to explain to the chancellor any deviations on the target and how he intended to rectify them. They differed often over the estimates of inflation and interest rates needed to keep inflation stable. In 1997, the Bank of England was given mandate to set interest rates. The inflation target was set at 2.5% unlike in the past where it was 2.5% or less. It was measured using RPIX inflation rate until 2003 when it was changed to harmonised index consumer prices (HICP) and later to consumer price index (CPI) of 2% which is in effect to date. The difference in the two price indexes is in their composition and coverage (Bank of England). Goods included in the index vary in price or price is measured differently depending on goods state. Consumer price index covers all consumers while retail price index excludes some groups of people. Overall, consumer price index produces low inflation target as the prices in economy are low. The monetary policy committee was instituted and given the responsibility of setting interest rates in such a way that the real inflation rate is similar or almost similar to the one set by government. Role of Bank of England and Monetary Policy Committee The committee consists of nine members; five from Bank of England and four are experts appointed by government to offer economic advice to the rest of the member’s (Bank of England, 2010). Interest rates are vital in forecasting rate of inflation as they are used to control demand and hence the level of inflation. The task of setting targets remained with the chancellor and the task of the committee was to ensure inflation target by government is attained or is close to target. The bank is thus responsible for maintaining price stability and enhancing government policies. Each member of the committee is expected to contribute in setting interest by indicating the rate he/she thinks is suitable. The suggestions are put forward during the various meetings held by the committee. A treasury representative is usually present to enlighten the members on government policies and inform the chancellor of developments by the committee at all times. The bank staffs are essential to the committee. They brief the members on current economic trends so that they can make informed decisions. The bank also has agents situated in all parts of the country to give information based on facts on the ground to the committee about businesses and organizations. After suggestions are forwarded and discussed, the governor chooses the best alternative based on the discussions and every member votes for or against and if it is accepted, it is forwarded to the government. Besides setting interest rates, the members have the role of communicating to the public and explaining policy decisions. They also publish the report of the meetings and make them public. They also have the task of explaining to the parliamentary committee of their actions especially if the inflation target achieved is below or above the one set by government. It is the banks duty to publish inflation reports which consist of the committees inflation forecasts so that the public knows what prices to expect and hence make informed decisions. They also understand how the economy is growing. The most important task of the bank is to meet government inflation targets and the role of monetary policy committee it to set interest rates in such a way that will enable inflation target to be realised (Bank of England, 2000-10). How Inflation Targeting Works Inflation targeting involves building public confidence on the efficiency of monetary policy strategies. The British government first establishes its objective which is; to stabilize prices. Price stability controls the level of output and employment in the economy thereby achieving economic growth (Russo-British, 2006). Setting objectives makes it easy for government to design ways of achieving the objective. The government further communicates its objective to the public thus making them aware on the direction prices will take; whether increases or reduction. The public is therefore able to understand and make informed decisions based on the objective and avoid future problems such as effects of inflation. Employers are able to determine wage rates and decide on recruitment while Investors are able to know whether to increase investments or save more hence working towards stabilizing prices by knowing inflation expected (Good hart, 2005). The government also abolished range targets with point target which is easier to understand and forecast. A range target makes the public uncertain of what is expected and hence cannot make proper decisions or act according to the expectations of inflation targets ( Roberts, 2006). Benefits of Inflation Targeting Inflation targeting has numerous benefits to public as well as central bank. It has contributed to low inflation rates and reduced price variations. This is beneficial for economic growth. It improves the understanding of monetary policy by the public and thus they are able to respond accordingly and have confidence in the government (Gavin, 2004). The credibility of monetary policy was achieved and the government is able to meet its objectives. The government also realised the effects of short term policies in the long-run and hence can make proper decisions. However, inflation targeting has its negative side. Short-run effects are overlooked and various variables affect inflation such as supply shocks. The target does not provide for housing booms which create unbalanced economy and keeping inflation close to target is costly. Success of the policy The success of Britain over past years can be attributed to inflation targeting. Since its inception in 1992 after the exchange crisis, the economy has been experiencing growth. More growth was recorded especially in 1997 after the Bank of England was granted independence over interest rates. Communication of inflation targets to public also contributes to success. United Kingdom inflation has remained close to government target of 2% which is lower than inflation of 1980 which was 10% (Bank of England, 2010). The retail price inflation average per year since 1993 was 3% and in 1997, it was slightly above 2.5 %.( Blejer et al. 2000). Range targeting used in 1992-1995 was treated with indifference by policy makers. A more developed point target was instituted at the end of the year 1995 hence fall in inflation expectations. According to British chamber of commerce (2006), Britain had the strongest business environment for the period 2005-2009 and a low unemployment which is below European Union average. However, recently the development trend has been affected by housing boom. Inflation is in 2009 was 1% and is expected to drop to 0.5% this year. Since there has been no recessions recorded in the last 15 years we can only conclude that the policy is a success. Conclusion Inflation is a very essential component in stabilizing an economy. By setting target inflation and communicating the same to the public, good results are attained. The public is able to understand the monetary policy and adjust their prices in accordance with the set target. The government is also able to attain credibility and have sound decisions that improve the economy. Inflation targeting is based on the belief that price stability is the main goal of monetary policy. A good inflation target involves transparency and flexibility and unlike monetary targeting any information is useful in its setting. It has a point target as opposed to range target so as to clear uncertainties and build public confidence. Inflation targets however, are affected by unexpected factors like weather in short-run but this does not warrant for alterations in interest rates. The Bank of England and the monetary policy committee have the responsibility of setting interest rates to make sure real inflation is close to the targeted inflation. Inflation target in UK has led to reduction in inflation rates and this is a good policy to be enumerated by other countries. References Bank of England. 2000-10. “An Independent Bank of England”. 12 Mar 2010. http://www.bankofengland.co.ku/education/targettwopointzero/mpframework/independentBankEngland.html> Bernanke, B., Laubach, T., Mushkin and Posen. 1999. Inflation Targeting: Lessons from the International Experience. New Jersey: Princeton university press. Blejer, Alain, Leone, Werlang. 2000. Inflation Targeting in Practice: Strategic and Operational Issues and Application to Emerging Market Economies. Washington DC: IMF. British Chamber of Commerce. 2006. “UK Economy.” UK Trade and Investments. 18 Mar 2010. < www.ukinvest.gov.uk> Gavin, T. 2004. “Inflation Targeting: Why It Works and How to Make It Work Better”. Business Economics. Vol. 39, 2 pp.30-37. Goodheart, C. 2005. “The Monetary policy Committee Reaction Function: An Exercise in Estimation”. Topics in Macroeconomics. Vol. 5, 1. Office for National Statistics. 24 mar 2010. Inflation. Roberts, J. 2006. “Monetary Policy and Inflation Dynamics”. International Journal of Central Banking. Federal Reserve Board. Truman, E. 2003. Information Targeting in the World Economy. Washington DC: Institute for International Economies. Read More