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Inflation targeting
In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability, and price stability is achieved by controlling inflation. The central bank uses short-term interest rates as its main monetary instrument.
An inflation-targeting central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation. The first three countries to implement fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier. As of 2024, inflation targeting has been adopted by 45 individual countries and the Euro Area as their monetary policy framework.
Early proposals of monetary systems targeting the price level or the inflation rate, rather than the exchange rate, followed the general crisis of the gold standard after World War I. Irving Fisher proposed a "compensated dollar" system in which the gold content in paper money would vary with the price of goods in terms of gold, so that the price level in terms of paper money would stay fixed. Fisher's proposal was a first attempt to target prices while retaining the automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes advocated what we would now call an inflation targeting scheme. In the context of sudden inflations and deflations in the international economy right after World War I, Keynes recommended a policy of exchange-rate flexibility, appreciating the currency as a response to international inflation and depreciating it when there are international deflationary forces, so that internal prices remained more or less stable. Interest in inflation targeting waned during the Bretton Woods era (1944–1971), as they were inconsistent with the exchange rate pegs that prevailed during three decades after World War II.
Inflation targeting was pioneered in New Zealand in 1990. The government and the Reserve Bank of New Zealand adopted a Policy Target Agreement (PTA) in March 1990 in which the Reserve Bank of New Zealand would pursue an inflation target range of 0 to 2 percent. Canada was the second country to formally adopt inflation targeting in February 1991.
The United Kingdom adopted inflation targeting in October 1992 after exiting the European Exchange Rate Mechanism. The Bank of England's Monetary Policy Committee was given sole responsibility in 1998 for setting interest rates to meet the Government's Retail Prices Index (RPI) inflation target of 2.5%. The target changed to 2% in December 2003 when the Consumer Price Index (CPI) replaced the Retail Prices Index as the UK Treasury's inflation index. If inflation overshoots or undershoots the target by more than 1%, the Governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining why, and how he will remedy the situation. The success of inflation targeting in the United Kingdom has been attributed to the bank's focus on transparency. The Bank of England has been a leader in producing innovative ways of communicating information to the public, especially through its Inflation Report, which have been emulated by many other central banks.
Inflation targeting then spread to other advanced economies in the 1990s and began to spread to emerging markets beginning in the 2000s.
Although the ECB does not consider itself to be an inflation-targeting central bank, after the inception of the euro in January 1999, the objective of the European Central Bank (ECB) has been to maintain price stability within the Eurozone. The Governing Council of the ECB in October 1998 defined price stability as inflation of under 2%, "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%" and added that price stability "was to be maintained over the medium term". The Governing Council confirmed this definition in May 2003 following a thorough evaluation of the ECB's monetary policy strategy. On that occasion, the Governing Council clarified that "in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term". Since then, the numerical target of 2% has become common for major developed economies, including the United States (since January 2012) and Japan (since January 2013).
On 8 July 2021, the ECB changed its inflation target to a symmetrical 2% over the medium term. Symmetry in the inflation target means that the Governing Council considers negative and positive deviations of inflation from the target to be equally undesirable.
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Inflation targeting
In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability, and price stability is achieved by controlling inflation. The central bank uses short-term interest rates as its main monetary instrument.
An inflation-targeting central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation. The first three countries to implement fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier. As of 2024, inflation targeting has been adopted by 45 individual countries and the Euro Area as their monetary policy framework.
Early proposals of monetary systems targeting the price level or the inflation rate, rather than the exchange rate, followed the general crisis of the gold standard after World War I. Irving Fisher proposed a "compensated dollar" system in which the gold content in paper money would vary with the price of goods in terms of gold, so that the price level in terms of paper money would stay fixed. Fisher's proposal was a first attempt to target prices while retaining the automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes advocated what we would now call an inflation targeting scheme. In the context of sudden inflations and deflations in the international economy right after World War I, Keynes recommended a policy of exchange-rate flexibility, appreciating the currency as a response to international inflation and depreciating it when there are international deflationary forces, so that internal prices remained more or less stable. Interest in inflation targeting waned during the Bretton Woods era (1944–1971), as they were inconsistent with the exchange rate pegs that prevailed during three decades after World War II.
Inflation targeting was pioneered in New Zealand in 1990. The government and the Reserve Bank of New Zealand adopted a Policy Target Agreement (PTA) in March 1990 in which the Reserve Bank of New Zealand would pursue an inflation target range of 0 to 2 percent. Canada was the second country to formally adopt inflation targeting in February 1991.
The United Kingdom adopted inflation targeting in October 1992 after exiting the European Exchange Rate Mechanism. The Bank of England's Monetary Policy Committee was given sole responsibility in 1998 for setting interest rates to meet the Government's Retail Prices Index (RPI) inflation target of 2.5%. The target changed to 2% in December 2003 when the Consumer Price Index (CPI) replaced the Retail Prices Index as the UK Treasury's inflation index. If inflation overshoots or undershoots the target by more than 1%, the Governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining why, and how he will remedy the situation. The success of inflation targeting in the United Kingdom has been attributed to the bank's focus on transparency. The Bank of England has been a leader in producing innovative ways of communicating information to the public, especially through its Inflation Report, which have been emulated by many other central banks.
Inflation targeting then spread to other advanced economies in the 1990s and began to spread to emerging markets beginning in the 2000s.
Although the ECB does not consider itself to be an inflation-targeting central bank, after the inception of the euro in January 1999, the objective of the European Central Bank (ECB) has been to maintain price stability within the Eurozone. The Governing Council of the ECB in October 1998 defined price stability as inflation of under 2%, "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%" and added that price stability "was to be maintained over the medium term". The Governing Council confirmed this definition in May 2003 following a thorough evaluation of the ECB's monetary policy strategy. On that occasion, the Governing Council clarified that "in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term". Since then, the numerical target of 2% has become common for major developed economies, including the United States (since January 2012) and Japan (since January 2013).
On 8 July 2021, the ECB changed its inflation target to a symmetrical 2% over the medium term. Symmetry in the inflation target means that the Governing Council considers negative and positive deviations of inflation from the target to be equally undesirable.