The UK government has given the Bank of England an inflation target of CPI 2 % +/-1. The Bank of England are responsible for using monetary policy (e.g. interest rates) to achieve this goal of low inflation. But, as well as targeting inflation, the Bank of England also have a wider remit of considering objectives such as economic growth.
Summary – Should we aim for low inflation as the primary objective?
Since the spikes in inflation during the 1970s and 1980s, many economies have prioritised low inflation as the primary objective of monetary and economic policy. Low inflation has many benefits for an economy; it is seen as a building block for stability and encouraging investment. The hope is that by keeping inflation low, the economy will avoid boom and bust economic cycles and provide a framework for economic stability and prosperity. If inflation gets out of hand, the economy will experience various costs of uncertainty, menu costs and loss of international competitiveness.
However, since the crisis of 2008, some economists have become increasingly critical of monetary / economic policy which targets low inflation and ignores other economic objectives such as full employment and economic growth. Critics argue that inflation targets can become too rigid, and recently (especially in Europe) the goal of low inflation has caused unnecessarily high unemployment and a prolonged recession.
Reasons why low inflation is a primary macroeconomic objective
There are many benefits of low inflation. Firstly, if inflation is low and stable, firms will be more confident and optimistic to invest; this will lead to an increase in productive capacity and enable higher rates of economic growth in the future.
If inflation is allowed to increase because monetary policy is too lax, there could be an economic boom. But if this rate of economic growth is above the long run trend rate of growth, it is likely to be unsustainable and the boom will be followed by a bust (recession). This occurred in the UK in the late 1980s and 1990s. Economic growth was too fast, causing demand pull inflation. By the time inflation increased to 10%, it was too late, and the UK needed a rapid increase in interest rates, which caused the recession of 1991/92. Maintaining low inflation will help avoid these cyclical fluctuations in the economy which can cause booms and recessions
If inflation in the UK is higher than other countries, UK goods will become uncompetitive causing a fall in exports and possibly a deterioration in the current account of the balance of payments. This is particularly important if a country is in a single currency or fixed exchange rate because they can’t devalue to restore competitiveness. Keeping inflation low, will help the UK to be competitive. Low inflation will also help to increase the value of the Pound and maintain living standards. Continue Reading →