It was noted that Central Banks have been successful in their policies which controlled inflation particularly in controlling insulating countries from shocks such as high oil prices. This mechanism will be explained using various macroeconomic principles.
The money supply is directly linked with inflation as shown in the famous Quantity Theory of Money (QTM). This model links the level of money supply to the level of prices of goods and services sold, thus inflation. The famous equation of the TQM is MV = PT, where P is the average price level, T is the volume of transactions of goods and services, V is the velocity of circulation, and M is the money supply in the economy. From this equation, we can see that money supply and price level have direct relationship. We should note that TQM assumes that V and T are constant in the short term, leaving only M and P variable. Consequently, when the money supply doubles, the price level in the economy also doubles. Thus, Central Banks can either increase or decrease the money supply in order to do the same in inflation.
In the statement being analyzed, Central Banks are able to avoid wage-price spirals (which are considered P in the QTM) by pursuing a contractionary monetary policy. According to Mishkin (2004), lowering the money supply is done by raising discount rates which discourages bank borrowings, open market sale which tightens reserves and monetary base, and raise the reserve requirement among banks which shrinks the available funds for banks to grant as loans to borrowers.
Also, another method usually done in open economies and has replaced monetary targeting is called inflation targeting. Inflation targeting is "an economic policy in which the central bank of a country estimates and makes public a projected or 'target' inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools (Inflation Targeting 2006)." Instead of directly controlling inflation by changing the level of money supply, central banks opted to manipulate interest rates. As interest rates and inflation are inversely related, the central bank raises interest rates if inflation appears to move above its target. Meanwhile, if inflation appears to be below the target, the central bank will lower interest rates. This policy has been adopted first by New Zealand in 1989. Inflation targeting has also been adopted by countries like the United States, Britain, South Korea, and Brazil.
Inflation targeters have also set a time horizon over which to reach their targets. This usually depends on how high the starting rate of inflation is relative to the desired rate. Since, inflation targeting requires transparency; central banks periodically release inflation reports, and press statements (IMF 2003).
2. Outline the effects of such monetary policy on price expectations in the central bank's domestic economy.
Inflation targeting, in order to be fully effective in curbing hyperinflationary expectations require transparency which