A Review of Optimal Inflation Targeting, What Should Be the Threshold Inflation Target?

Yetsedaw Emagne Bekele

doi:10.7176/jesd/10-3-09

Abstract

Although it is widely acknowledged that most of developed countries have inflation targeting in order to control sustainable economic growth these review attempted to answer some questions about the optimal inflation target foe the European central bank. The review was made based on secondary data from Eurostat data base, different articles and annual reports of the central bank of Europe.We found that the threshold inflation target to be in the form of interval with an upper bound of 4 percent and lower bound of 2 percent. Based on the objectives of maintaining sustainable economic growth in the region, the threshold level of inflation is found to be 11 - 16 percent per year for low income countries, 15 - 21 % per year for lower middle-income countries, and 4 - 5 % for upper middle-income countries. Hence, 2 % as well as 4 % of current upper bound of inflation target in Euro Area fall within this range. The interval from 0 percent to 2 percent is reasonable because low positive inflation is easier for firms to decrease real wages to maintain employment (downward rigidity) when it is necessary without reducing nominal wages. Accordingly, the measures taken by ECB [1] to deal with the problem active quantitative easing program (QE), as shown in the experience of USA, UK and Japan, are not solely efficient. Keywords : European central Bank, Sustainable economic growth, Inflation Targeting DOI : 10.7176/JESD/10-3-09 [1] European Central Bank

Highlights

Nowadays, sustainable economic growth concurrently with price stability is the main goals of macroeconomic policy in developed and developing countries
What does define the inflation target? Which factors have an impact on setting it? Her Majesty Queen Elizabeth II, Donald Trump or, may be some things connected with costs of inflation, inflation expectations and interest rates? To answer this question, we briefly showed the results of econometric model by Horváth and Matějů who collected responses from 19 central banks about setting lower and upper bound of inflation target
The right inflation target should be set in the form of zone with upper and lower bounds to have “hard” floor and ceilings which could define the mid-point of inflation

Summary

Introduction

Sustainable economic growth concurrently with price stability is the main goals of macroeconomic policy in developed and developing countries. Responses from central banks stated that during setting of inflation target they judge about it based on such determinants as costs of inflation, past inflation, inflation expectations, price convergence, measurement error, wage rigidities, zero interest rate bound, foreign inflation, economic growth, risks of deflation, business cycle fluctuations, Maastricht inflation criterion for euro adoption. If we have a look on current situation (Graph 3), we find that across the Euro Area the actual rate of inflation still did not reach its current target and has a downward trend (Gros, Alcidi, Groen, 2015) Such highly expansionary monetary policy of ECB as QE has largely succeeded in dealing with financial instability and reducing pressure on bank debt and government bonds markets, but has not deal with risk of coming into deflation trap. Euro Area will be significantly lower than in the US, as the rates in the euro zone are too low (0,05 % and - 0,2 % for deposits), and the banking system is not flexible enough to increase lending

Aim

Findings

Conclusions and Recommendations