2. The Rationale for Inflation Targeting

Abstract

The decision to organize a country's monetary strategy around the direct targeting of inflation rests upon a number of economic arguments about what monetary policy can and cannot do. Over the last twenty years, a consensus has been emerging in the economics profession that activist monetary policy to stimulate output and reduce unemployment beyond their sustainable levels leads to higher inflation but not to persistently lower unemployment or higher output. Thus, the commitment to price stability as the primary goal for monetary policy has been spreading throughout the world. Along with actual events, four intellectual developments have led the economics profession to this consensus. WHY PRICE STABILITY? The first intellectual development challenging the use of an activist monetary policy to stimulate output and reduce unemployment is the finding, most forcefully articulated by Milton Friedman, that the effects of monetary policy have long and variable lags.(1) The uncertainty of the timing and the size of monetary policy effects makes it very possible that attempts to stabilize output fluctuations may not have the desired results. In fact, activist monetary policy can at times be counterproductive, pushing the economy further away from equilibrium, particularly when the stance of monetary policy is unclear to the public and even to policymakers. This lack of clarity makes it very difficult for policymakers to successfully design policy to reduce output and unemployment fluctuations.(2) The second development is the general acceptance of the view that there is no long-run trade-off between inflation and unemployment.(3) The so-called Phillips curve relationship illustrates the empirical regularity that a lower unemployment rate or higher output can be achieved in the short run by expansionary policy that leads to higher inflation. As prices rise, households and businesses spend and produce more because they temporarily believe themselves to be better off as a result of higher nominal wages and profits, or because they perceive that demand in the economy is growing. In the long run, however, the rise in output or decline in unemployment cannot persist because of capacity constraints in the economy, while the rise in inflation can persist because it becomes embedded in price expectations. Thus, over the long run, attempts to exploit the short-run Phillips curve trade-off only result in higher inflation, but have no benefit for real economic activity. The third intellectual development calling into question the use of an activist monetary policy to stimulate output and reduce unemployment is commonly referred to as the time-inconsistency problem of monetary policy.(4) The time-inconsistency problem stems from the view that wage- and price-setting behavior is influenced by expectations of future monetary policy. A frequent starting point for discussing policy decisions is to assume that private sector expectations are given at the time policy is made. With expectations fixed, policymakers know they can boost economic output (or lower unemployment) by pursuing monetary policy that is more expansionary than expected. As a result, policymakers who have a stronger interest in output than in inflation performance will try to produce monetary policy that is more expansionary than expected. However, because workers and firms make decisions about wages and prices on the basis of their expectations about policy, they will recognize the policymakers' incentive for expansionary monetary policy and so will raise their expectations of inflation. As a result, wages and prices will rise. The outcome, in these time-inconsistency models, is that policymakers are actually unable to fool workers and firms, so that on average output will not be higher under such a strategy; unfortunately, however, inflation will be. The time-inconsistency problem suggests that a central bank actively pursuing output goals may end up with a bias to high inflation with no gains in output. …