Macroeconomics Assignment

What is inflation?
Inflation, which is defined by Frederic Mishkin (2007) as the condition of a continually and
rapidly rising price level is similar in some sense as water is to human beings. Too much water
(hyperinflation) causes massive floods while the lack of water or the absence of water (deflation)
causes droughts. What is required is a steady and constant supply of water which central banks
commonly refer to as low and stable inflation.

Controlling Inflation
We must first discuss some of the basic requirements that these strategies must solve in order for
them to be viable and feasible from an economic point of view include the attainment of price
stability which is seen to be a long-run goal for a number of central banks today. This is because
price stability encourages healthy economic growth by lowering uncertainty, information
distortion, and preventing overinvestment in the financial sector (to escape inflation). A strategy
to control inflation must also be able to avoid the trap of time-inconsistency whereby short run
‘gains’ (employment and higher economic output) might bring long run ‘pains’ (inflation).
Besides that, monetary policy should be forward looking. This is because they are time lags and
price stickiness that may delay the effects of monetary policy. The next criterion
is accountability and transparency that will force central banks to be responsible and to also
serve as a benchmark of performance. Furthermore, any strategy to control inflation must also
take into account their effects on economic output as this variable is also important to an
economy’s well-being. Lastly, the flexibility and independence of central banks must also be
present as empirical evidence shows us that independent central banks tend to perform better
than their counterparts.

Inflation Targeting
The strategy to control inflation is through inflation targeting which is done through a public
announcement of medium term numerical targets for inflation with a commitment by monetary
authorities to achieve these targets. The main advantages of inflation targeting include the
increased accountability of the central bank to achieve its inflation target and with that
eliminating to a certain extent the time-inconsistency problem. Furthermore, inflation targeting
does not require a stable money-inflation relationship thereby giving the central bank full
flexibility in setting the best domestic monetary policy.
Inflation targeting also has weaknesses as inflation is not as easily controlled compared to
exchange rates and monetary aggregates. Going deeper into the subject, long lags in monetary
policy also causes inflation outcomes to occur after a longer period of time thereby making
inflation targets not an immediate signal to the public and market on the stance of monetary
policy. Besides that, inflation targeting is argued to give central banks too little discretion to
respond to unforeseen circumstances. More importantly however, is that inflation targeting may
lead to larger output fluctuations and increased unemployment in order to achieve price stability.
Other arguments against inflation targeting include GDP targeting (however the argument
against GDP targeting is also strong).
Inflation targeting has recently become very popular among central banks. Its various advantages
(compared to other strategies) cannot be discounted. Inflation targeting makes a solid and firm
commitment towards price stability which in one fell strike answers to price stability as a long-
term goal, counters the time-inconsistency problem, and makes central banks both accountable
and highly transparent. Some economists however argue that inflation targeting is too rigid and
thereby limiting the ability of the central banks to be independent and forward looking. Also
taken into consideration is that inflation targeting might overemphasize the goal of price stability
and may neglect economic output as another major goal of monetary policy. Much credit has
however been given to inflation targeting as the ideal monetary policy strategy against inflation
as countries adopting this strategy have achieved both lower inflation and higher real growth.
Countries that have adopted this strategy (United Kingdom, Canada, and New Zealand) are seen
to achieve remarkable results in terms of controlling inflation.

Conclusion
The Great Inflation of the late 1970s gave way to an age of low, and steady inflation thanks in
part to the skill with which central banks learnt to steer monetary policy. The current age of low
and steady inflation in industrialized countries might not last forever. Exchange rate imbalances
(like those of the USD being overvalued and the Yuan being undervalued) coupled with financial
globalization has killed inflationary pressures by providing first world countries with cheap
imports and labor from third world countries. As foreign direct investments continue to flow into
China and India (creating inflationary pressures there), it is only a matter of time when this
‘happy hour’ comes to an end. Furthermore, the shrinking middle class and low birth rates of
industrialized countries might lead to a death loop by people spending more than they earn,
borrowing more than they can afford and governments indirectly printing more money to solve
budget deficits. In an age that Alan Greenspan coined as the ‘Age of Turbulence’, economists
must never underestimate the destructive power of high inflation.

Made By – Sheetal Jaimalani