2. In the debate between inflation targeting and monetary targeting
has been going on since the 1980’s. Both sides argue on how a country
should establish credibility and stability for a countries central
bank. However, inflation targeting is the strongest and most credible
of all the possible monetary policy targeting systems.
The idea behind inflation targeting is setting a range of
inflation rates, above zero and usually around 2 with no more than 4
for some counties, and using monetary policy tools to keep inflation
within that range. Much of the reasoning of inflation targeting comes
from former Chairman of the Federal Reserve Ben Bernanke, who
supported the idea of inflation targeting along with what he calls
constrained discretion. During his inauguration in 2006, he ensured
the people of the United States that he will stick to his constrained
discretion, gave confidence in the Federal Reserve’s policies, and
gave promise how he will work diligently to keep the American
financial system working (Bush).
In his paper written with Frederick Mishkin, “Inflation
Targeting: a New Framework for Monetary Policy?”, the discuss how a
central bank can set a policy called ‘Constrained Discretion’. This
idea is a sort of hybrid of rules and discretion, giving the central
bank power to divert from strict rules and set for policy that can
change macroeconomic outcomes. He argued this would give the central
bank credibility because they can change rates without effecting
rational expectations.
3. When Bernanke became Head Chairman of the Federal Reserve in
2006, he implemented his concept of constrained discretion, which
allowed the Fed to use medium-term goals of 4-5 year targets of an
inflation rate, but allowed for policy to deviate if there were some
sort of shock or recession in the economy. The Fed can then make use
of its “escape clause, which permits the inflation target to be
suspended or modified in the face of constant adverse economic
developments” (NBER 5). Doing this gives credibility to the central
bank because they know once the temporary event or shock is over,
policies will return macroeconomic outcomes, primarily inflation, back
to previous levels. Rational expectations do not change in the long
run.
Given that the United States has been an inflation targeting
country since the 1980’s, we have relatively low levels of inflation
since that period of time. Even though we were struck with the second
worst recession in American history, inflation number haven’t risen
above 5% since there was the implementation of the target. Prices have
become relatively stable and growth has stayed at a steady upward
trend.
In Michael Dueker and Andreas M. Fischer’s “Inflation Targeting
in a Small Open Economy: Empirical Results from Switzerland”, they
bring evidence from Switzerland, who for some time had used a monetary
target policy, had issues with price levels when exchange rates
changed. They argue that using an inflation rate will keep a lot of
Switzerland’s inflation issues in check and keep the economy more
stable than otherwise.
4. Empirical evidence comes from the Swiss National back in the
1970’s and 1980’s. When looking at the data, and using predicted
models, the predicted monetary base growth was extremely consistent
with the actual monetary base growth with hardly ever deviating
greater than 0.5%. While this is good, the predicted inflation rate
and the actual inflation rate rarely ever were close to each other.
The model predicted inflation wouldn’t rise more than 3%, while it at
points was upward of 6-7%. This leads to uncertainty in the private
sector because they believe that their central bank is going keep
prices stable when in fact inflation was rising.
This in turn causes people to become uncertain of the central
banks motives, as well as giving people inaccurate information on long
term inflation rates. People cannot accurately plan of their futures
if they do not know what rate their money is depreciating. If a
central bank were to impose an inflation targeting policy (given they
are credible), the people can accurately know how to plan for the
future knowing that if there are any short run shocks, the government
has a plan to return to Optimal Long run Inflation Rate (Dueker).
Simply put, in most cases, holding an inflation target generally
keeps monetary targets in check as well. This comes from the Central
banks tool, monetary policy, to affect the supply of money in the
market. Other countries have shown similar results, such as Germany,
who’s “Central Bank has often chosen to miss money targets to ensure
price stability. Money targets are generally consistent with inflation
targets” (NBER 7). Meeting inflation goals seem to be more important
to central bankers than hitting monetary targets. Why is that?
5. It comes from the fact that people are generally more concerned
over inflation rather than GDP growth or exchange rates or money
supply. Inflation is directly applicable to them, because it affects
their future planning. They have to recognize what period will they
perform more leisure and which periods they will work to gain higher
return. If most of their money is becoming devalued over time, it will
affect their behaviors.
We can see that from the graphs given in Dueker and Fischer’s
paper “Inflation targeting in a Small Open Economy; Empirical Results
from Switzerland”, that back in the first two cycles of inflation (’74
and ’81) there are increases in money growth before and decreases
after. But in 1991 there were decreases in money growth, ’88 shock was
not a period of monetary tightening. More or less their exchange rate
and money supply focus caused two periods of inflation. Changing to a
monetary policy where its focus is to keep inflation and prices
stable, leads to an economy that can ensure prices will stay
relatively unchanged over medium to long periods to time.
Due to Swiss being a small open economy, their currency greatly
depends on exchange rates and how they can trade currencies. It’s no
wonder than because of this they tried to focus on keeping the
exchange rate stable. The problem with that however, is that central
banks cannot control the other side of the exchange rate equation,
what the other currency is worth; They can only control one side,
their own. And when inflation devalues their currency, it won’t matter
what others have done because their own money is worth less. That’s
why keeping an inflation target over an exchange rate policy is more
6. effective. As a result, the monetary base proved not to be a good
indicator for monetary policy during the transition period and the SNG
had to look to other indicators such as broader monetary aggregates,
interest rates and exchange rates
More evidence to support how and inflation target is more
important than a monetary target is by looking at Carl E Walsh’s
“Inflation Targeting; What Have We Learned?”. From a report by Gali
and Gambetti, we see that “during 1984-2005 the standard deviation of
real U. S. GDP growth fell to less than half its 1948-1984 level”,
meaning the change from the mean during those periods shrunk (Walsh
6). This in turn means the US is having less volatility in the change
in GDP growth, and growing at a more constant rate. However, Walsh’s
findings on other countries after transitioning to inflation targeting
show that the mean of Industrial growth rates decreases after the
change, although standard deviation decreases as well. So even though
growth rates aren’t as large, the volatility in the rates tend to stay
more constant.
Overall, inflation targeting is optimal due to its positive
externality of also holding other macroeconomic outcomes, such as
exchange rates and output, at somewhat of a constant level, as well as
decreasing the volatility of the macro economy.
7. Work Cited
Bernanke, Ben S. “Inflation Targeting” Panel Discussion. Federal
Reserve Bank of St. Louis. August 2004. Web.
Bernanke, Ben S., and Frederick S. Mishkin. “Inflation Targeting: a
New Framework for Monetary Policy?”. NBER Working Paper.
National Bureau of Economic Research. January, 1997. Web.
Bush, George W., and Ben S. Bernanke. “President Attends Swearing-In
Ceremony for Federal Reserve Chairman Ben Bernanke”. The Federal
Reserve. Washington, D.C. February 6, 2006. Speech
Dueker, Michael, and Andreas M. Fischer. “Inflation Targeting in a
Small Open Economy: Empirical Results from Switzerland”. Journal
of Monetary Economics. The Federal Reserve Bank of St. Louis.
February, 1996.
Mishkin, Frederic S. “Macroeconomics Policy and Practice”. Pearson
Textbooks. Columbia University. 2015. Print.
Walsh, Carl E. “Inflation Targeting: What Have We Learned?”.
University of California, Santa Cruz. July, 2008. Web
