Why is the Government’s Inflation Target 2%

Why is the Bank of England Inflation target 2%? Why not 0% or 5%. Central Banks around the world have tended to converge on this figure of 2% as being the ideal inflation rate. This is because

Inflation has various costs

• Uncertainty. When inflation is high firms are more reluctant to invest becuase they are uncertain about future prices. Low inflation creates more stability and confidence to invest
• Less Competitive. If UK inflation is higher than elsewhere, then our exports become less competitive leading to lower exports and depreciation in exchange rate.
• Menu costs. This is costs of change price lists.
• Boom and Bust Cycles. High inflation accompanies unsustainable economic growth; this invariably leads to a boom followed by bust. e.g Lawson Boom was followed by recession of 1991. Low inflation enables stable growth.

Deflation also has various costs

• When prices are falling consumers delay purchasing goods because they will be cheaper in the future. This can cause a fall in aggregate demand
• Real interest rates become too high. Interest rates can’t fall below 0%. therefore if prices are falling, real interest rates may be too high and this will cause a further fall in AD.
• Real Wages may be too high. Workers are very resistant to nominal wage cuts. So if prices are falling, real wages will be rising and this could cause real wage unemployment

Inflation is harmful; but deflation is also very harmful This is why governments do not aim for inflation of 0%. Therefore, the government aim for an inflation rate of 2%; this enables prices and wages to adjust without causing the uncertainty of higher inflation rates.

Low inflation is also closely linked to the goal of stable economic growth.