Question

How does a monetary policy of inflation target work $?$

Short answer

Monetary policy of inflation target stimulates the economy.

Step-by-step solution

Concept

Inflation refers to the situation when the general price level of goods and services in an economy increases. It can be caused by an increase in money supply.

The role of the central bank.

The central bank of an economy, on the behalf of the governemnt determines a target inflation rate that is desirable in the economy. The monetary policy is then changed accordingly to keep the actual inflation around this rate.

Inflation target rate

If the inflation is greater than the desirable rate, a contractionary policy is adopted to reduce the inflation rate through decline in money supply.

Similarly, an expansionary policy is adopted when the inflation is lower than the desirable rate, through an increase in money supply. Bank rates, open market operations, liquidity rates, etc. are tools used to influence money supply. Most national banks utilize an expansion focus of 2%.