Readers Question: Explain how monetary policy works under an inflation targeting regime.
I have written some answers to this question on previous occasions. These answers should help:
Meaning of Inflation Targeting
Inflation Targeting means that the Central Bank has a primary objective of achieving the Government’s inflation target. This means in theory they do not target other macroeconomic objectives like unemployment and growth (although in practice they may worry about a recession).
It also means they don’t target inflation indirectly. e.g. fixing currency or targeting money supply.
Inflation Targeting in UK
Since 1997, the UK has been a good example of Inflation Targeting.
The government set the inflation target of CPI 2% +/-1. This means the bank is committed to keeping inflation within the range of 1-3%.
Monetary policy is operated by the Monetary Policy Committee (MPC) which is part of an independent Bank of England. This means the government cannot interfere in Monetary policy decisions.
The MPC use interest rates to try an achieve this goal. In exceptional circumstances, they may also use unorthodox monetary policies such as quantitative easing.
It is hoped that having an inflation target will reduce inflation expectations and therefore make it easier to maintain low inflation.
How Monetary Policy Works
If inflation is above the government’s target, the MPC will probably decide to increase interest rates. Higher interest rates increase the cost of borrowing and reduce consumer spending and investment. This should lead to a slower growth in AD and lower inflation.
If inflation was below target and the rate of economic growth very low, the MPC would be likely to cut interest rates to try and stimulate AD.
Inflation Targeting in US
In US, the policy is slightly different because the Fed have two objectives. One is to target low inflation, the other is to maintain full employment. At the moment the Fed is cutting interest rates to try and avoid recession, they are not too worried if inflation increases.