Inflation Targeting Analysis - Case Study Example

Inflation Targeting Inflation is the unpredictable future crisis in the modern economy which has positive as well as negative impacts on financial market. When the demand is more than available supply, there will be an upward movement in the prices of goods and services but a decline in the value of money as well all which constitute inflation. Consumer Price Index and Product Price Index are the tools used to measure the inflation rate. The diminution of purchasing power of the money is most adverse effect of inflation by which customer cannot acquire as much goods and services he was able to purchase in the past. Similarly, inflation creates uncertainty about future and which discourage the savings and investments. In addition to this, inflation promotes speculation and hoarding since people concern further price rise in future and that produces shortage of goods. However, inflation can also contribute some benefits to the economy by enabling the central banks to vary nominal interest rates in order to mitigate the impacts of recession. Recently, some tools have developed with the intention of allaying the intensity of inflation. Inflation targeting is the most apt technique which is widely used across the globe. It is the policy used by central banks in which they fix appropriate inflation target and uses various monetary tools in order to reduce the gap between actual inflation rate and targeted inflation rate. New Zealand is the first country which adopted inflation targeting as their official strategy to control price values and thereby improve the economic growth of the country. By the adoption of inflation targeting method, NZ aims at the achievements of ‘effective forecasting technology, well-developed institutional structure and financial sector, and improved measures for the prevention of inflation’ (Blejer, Ize & Leone, 16). Impacts of inflation targeting on New Zealand In mid 1980’s, New Zealand’s economical structural reformation brought some worse situations into the financial stature of the country. Since NZ had not an independent central banking system, it was not in a position to fix a suitable level of inflation for the nation’s economy. As a result, the NZ’s financial policies could not keep the balance of economy which led to a significant inflation and thereby the destruction of economic system of the country. In order to maintain county’s price stability, the Reserve Bank of New Zealand Act of 1989 declared the independence of Reserve Bank of New Zealand and which came into force 1990. Its first economic agenda was the establishment of an inflation targeting system. The Consumer Price Index was above 5 at that time and the central bank fixed target inflation as 0-2. They set yearly targets also with the intention of leaping towards their ultimate objective as fast as possible. As the practice of inflation targeting had progressed, there were indications of country’s shifting changes towards the application of monetary tools such as interest rates and exchange rates. In addition to this, the efforts of the central bank got support from the public also which helped country’s mission a lot. As a result of NZ’s intensified efforts, they almost reached at their target by the end of 1990’s. As the New Zealand could effectively implement the inflation targeting policy, many other central banks also switched their demands to this tool. The components of inflation targeting suit with both developed as well as developing countries irrespective of their structure of the economy. The Sweden, Canada, and UK are the some the economies that follow inflation targeting as their valuable price stabilizing weapon. Inflation targeting and its significance As we discussed earlier, it is the best way to keep price stability in an economy by fixing inflation targets. Its major feature is that it can bring inflation under control within a short period of two or three years. An effectively developed inflation targeting policy, according to Bernanke & Woodford (1), enables the central banks to achieve other objectives also such as output stabilization in addition to the main goal of inflation control. Similarly central banks also target the attainment of ‘communication, transparency, and accountability’ by the adoption of inflation targeting (Bernanke & Woodford,1). This method is not much complex as compared to others; so the technique aids the central banks to elucidate its goals and policies for the public which is an inevitable factor in the successful implementation of any strategies. In addition to this, it will be helpful for the central banks to maintain stability in economic development if once it has achieved low inflation rate with the help of inflation targeting. The components illustrated below are necessary to plan and apply an inflation targeting weapon successfully. [Source; Truman, 2003:.6] Advantages of inflation targeting It assists the central bank to apply monetary policies in order to solve domestic economic crisis and difficulties associated with global market fluctuations. Inflation targeting also provides maximum information about money market and which help the central bank to use most fitted monetary instruments from time to time. Since the numerical target procedures of this tool promote effective accountability, the regulator can easily prepare various reports as soon as the fiscal year completes. Similarly it gives results within a short interval of time and thereby it is possible to reduce the volume of losses incur. In addition to this, “inflation targeting has the advantage of focusing the political debate on what a central bank can do on a sustainable basis” (Truman,14). In the same manner, it can engage in money market regulating activities without any specific authorization. Disadvantages of inflation targeting Even though it plays a crucial role in molding the economic structure of a country, it is criticized by some economists. The predetermined inflation target cannot be altered easily before its achievement; it reduces the flexibility of the instrument since proper response to unforeseen contingencies is not possible. Sometimes, the over concentration in reducing inflation rate may cause the instable output from the economic operations which leads to lower economic growth and unemployment. Similarly the results from the performance of inflation targeting instrument are obtained only after the completion of one fixed phase, it is not possible to make timely amendments. Likewise, the information forecasting technologies are not 100% percent reliable; hence a false market forecast will make more severe effects on the economy. Federal Reserve’s response to inflation targeting The Federal Reserve has not accepted the inflation targeting formally even though it uses this tool implicitly. The central banks consider its structure before the selection of a policy. The federal bank in the United States is independent from the government control and it operates as a separate legal entity. Similarly the Federal Reserve is the only authority to take decisions regarding the application of monetary policies and hence political interferences are not allowed. This practice helps the Federal Reserve’s policy makers for the effective implementation of their proposed policies. The inflation targeting system fixes target inflation for a long time. On the other hand, Federal Reserve adopts a more liberal policy by which they frequently adjust ‘federal fund rate targets’ in accordance with the indication of future inflation (Guttmann, 31). It helps the Fed policy makers to respond quickly to changing financial situations and thereby to make necessary adjustments in the structure of US economy. They give more emphasis on preventing recession rather than achieving fast economic growth. Similarly the Fed fits a high interest rate policy for the US economy with the intention of achieving the credibility of investors and shareholders. In addition to this, the Fed likes to follow a Keynesian means of development. So, the terms of inflation targeting technique is against the expectations of Federal Reserve and they refuse to accept it. Even though US follow an entirely different economic policy against inflation, they consider some of the aspects of inflation targeting for the set up of their economy. Works Cited Blejer, Mario. Ize, Alain and Leone, Alfredo M. Inflation targeting in practice: strategic and operational issues and application to emerging market economies.US: International Monetary Fund, 2000. Print. Bernanke, Ben and Woodford, Michael. The Inflation- Targeting Debate. London: University of Chicago Press, 2006. Print. Truman, Edwin M. Inflation Targeting in the World Economy. Washington: Institute for International Economics, 2003. Mishkin, Frederic and Savastano, M. A. Monetary Policy Strategies for Latin America, Policy Research Working Paper. World Bank Publications, 2001. Web. 3 Dec 2010. Guttmann, Robert (Ed.). Reforming money and finance: toward a new monetary regime. New York: Edition-2, M.E. Sharpe, 1997. Print. Read More