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Inflation targeting as a monetary policy rule

June 22, 2015
in Blog

Among economists who agree that monetary policy should be conducted according to predictable rules, perhaps no proposed rule enjoys greater support than inflation targeting.  In brief, inflation targeting means the central bank conducts monetary policy such that it comes as close as possible to creating (or rather, setting the macroeconomic conditions for markets to create) a pre-specified rate of inflation in every time period.  An example of an institution that has adopted an inflation target is the European Central Bank, which explicitly targets 2% inflation.

(As an aside, another kind of rule—price level targeting—is very closely related to inflation targeting.  Inflation is the growth rate of the price level, so if a central bank adopts a price level target rather than an inflation target, it is basically adopting an inflation target where the target rate is zero.  Price level targeting thus can be thought of as a special case of inflation targeting.  The pros and cons of inflation targeting, to be discussed, largely apply to price level targeting as well.)

Inflation targeting has several desirable features.  I will briefly discuss the three I believe are most important.

First, it is easy for the public, in their capacity as market actors, to understand.  Easily-understandable rules are better for securing economy-wide coordination of production and consumption choices.  Second, it provides a clear time path for the purchasing power of money.  Regular inflation, so long as it is low and predicable, probably does not hamper economic coordination, and by providing a long-term commitment for the rate of change of money’s purchasing power, market actors can safely make longer-term contracts than otherwise, which is beneficial for economic growth.  Third, it also can stabilize the economy in response to aggregate demand shocks.  For example, if the demand to hold money suddenly and unexpectedly rises, a central bank with an inflation target will have to engage in expansionary monetary policy if it wants to continue to hit its target.  From the standpoint of monetary equilibrium theory, this is desirable because it prevents unnecessary fluctuations in output and employment that would otherwise result from an unmet excess demand for money.

However, inflation targeting does have one serious drawback.  Just as inflation targeting can stabilize the economy in response to aggregate demand shocks, it can destabilize the economy in response to aggregate supply shocks.  Imagine the price of oil suddenly and unexpectedly rose, the classic example of a negative aggregate supply shock since the 1970’s.  Since oil is an input for many goods and services, this would result in production in general becoming more costly, and hence goods and services in general would become scarcer.  This would increase prices all across the economy, as a given quantity of money chases fewer goods and services.  However, since goods and services prices have gone up, inflation would now be higher than its target rate.  The central bank would have to engage in contractionary policy to bring inflation back to its target rate, which unfortunately would result in further reductions to real output, and rising unemployment.

As we’ve seen, inflation targeting has several advantages, and one serious disadvantage.  However, we cannot say whether inflation targeting is desirable unless we make a concrete comparison to some other rule.  It is probably true, though, that an imperfect rule is better than no rule at all.  If the choice were between a completely unconstrained central bank, and a central bank that followed an inflation target, I and many other economists would prefer the latter.

3 Comments

  1. Offshore Direct June 29, 2015 4:40 AM

    Interesting, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances,
    including during the recent global financial crisis. Individual countries, however, must assess their economies to determine
    whether inflation targeting is appropriate for them or if it can be tailored to suit their needs.

    Great post.

  2. koppl June 23, 2015 1:36 AM

    I'm not sure it makes sense to ask which rule is best given that no supposed rule can eliminate the infirmities of central banking with a fiat currency. Nevertheless, I might have thought you'd rank the Taylor rule above inflation targeting, Alex. If they actually follow the Taylor rule, it is less likely to have the destabilizing effect you note for targeting. One big problem, of course, is that they are likely to deviate from any rule sooner or later. Bernanke describes inflation targeting as "constrained discretion." I think Taylor gives them less wiggle room, doesn't it? Friedman changed his mind about what rule to use, but always stuck with the idea of an utterly rigid rule.

  3. vikingvista June 22, 2015 2:16 PM

    “if the demand to hold money suddenly and unexpectedly rises, a central bank with an inflation target will have to engage in expansionary monetary policy if it wants to continue to hit its target”

    Instead of inflation targeting, isn’t this interest rate targeting? Or are you saying that this case is identical to the case where demand for goods and services increases?

    Although a rise in interest rates caused by increased money demand may correlate with an increase in aggregate price of goods & services, surely this correlation isn’t unity.