Question

Which of the following statements is correct? (a) Inflation targeting implies the central bank can ignore what is happening to output. (b) Inflation targeting implies nominal interest rates will typically rise by more than the rise in inflation. (c) Inflation targeting was immediately abandoned once the financial crash of 2009 occurred.

Short answer

Option (b) is correct: nominal interest rates will typically rise more than the rise in inflation under inflation targeting.

Step-by-step solution

Understanding Inflation Targeting

Inflation targeting is a monetary policy regime where a central bank sets an explicit inflation rate as its goal and modifies monetary policy to achieve that rate over time. This involves monitoring various economic indicators, not just inflation.

Analyzing Option (a)

Option (a) states, 'Inflation targeting implies the central bank can ignore what is happening to output.' This is incorrect because while inflation targeting focuses on controlling inflation, central banks cannot ignore output changes since these affect inflation predictions and monetary policy adjustments.

Evaluating Option (b)

Option (b) posits, 'Inflation targeting implies nominal interest rates will typically rise by more than the rise in inflation.' According to the Taylor principle, for monetary policy to be effective, central banks must increase nominal interest rates by more than any increase in inflation to stabilize the economy, which aligns with this option.

Reviewing Option (c)

Option (c) states, 'Inflation targeting was immediately abandoned once the financial crash of 2009 occurred.' This is false, as most central banks maintained inflation targeting while adapting their approaches to address the crisis.

Choosing the Correct Statement

Upon evaluation, option (b) is the correct statement. It correctly reflects the Taylor principle's influence on inflation targeting and interest rate adjustments.

Key concepts

Monetary Policy

Monetary policy consists of the actions taken by a central bank to manage the economy by controlling interest rates and the money supply. It influences economic conditions by affecting spending, investment, and the rate of inflation. In the context of inflation targeting, monetary policy plays a vital role. Inflation targeting involves setting an explicit inflation rate as the primary goal of the central bank. This requires continuous monitoring of various economic indicators to determine the appropriate monetary policy path.

One of the main tools in this policy framework is adjusting the nominal interest rates. By doing so, the central bank can manage inflation and stabilize the economy. Reducing interest rates usually stimulates economic growth by encouraging borrowing and spending, whereas increasing rates can help curtail inflation by making borrowing costlier.

Inflation targeting does not mean ignoring other economic factors like output or employment. Central banks must consider these factors when making policy decisions because they influence the overall economic environment and inflation outlook. Thus, while inflation targeting focuses on inflation, it is inherently linked to broader economic conditions.

Taylor Principle

The Taylor Principle is an essential concept in monetary policy that guides how central banks adjust interest rates in response to changes in inflation. Named after economist John B. Taylor, it prescribes that central banks should raise nominal interest rates by more than the increase in inflation rates. This principle helps ensure real interest rates rise, thereby stabilizing the economy.

Let's break it down into simpler terms:

• If inflation rises, the Taylor Principle suggests that nominal interest rates must increase more significantly.
• This helps influence economic actors' behavior by effectively making borrowing and spending less attractive, thus managing demand and keeping inflation in check.
• Failure to raise interest rates enough could lead to an overheating economy, risk of long-term inflation, or a self-reinforcing inflationary cycle.

By adhering to this principle within the framework of inflation targeting, central banks aim to achieve a balance between price stability and economic growth. Adjusting interest rates properly ensures that inflation doesn’t spiral out of control and that economic activities remain sustainable.

Central Bank

Central banks are pivotal institutions in any economy, responsible for conducting monetary policy and ensuring financial stability. These institutions, such as the Federal Reserve in the USA or the European Central Bank in the Eurozone, play a crucial role in managing inflation and economic growth.

Under inflation targeting, central banks set a specific target for the inflation rate and guide monetary policy tools to achieve this target. During this process:

• They monitor a multitude of economic indicators, including GDP growth, employment rates, and consumer prices.
• They adjust monetary policy tools like interest rates to maintain economic stability and control inflation.
• Their actions are not solely dictated by inflation; they must consider broader economic impacts, such as output and employment.

Despite being challenged by economic crises, such as the 2009 financial crash, many central banks have maintained their commitment to inflation targeting. They adapted their strategies to address immediate issues while keeping long-term inflation goals in sight. This highlights the central bank's ability to adjust and manage both short-term economic demands and long-term price stability objectives.