13.2 Inflation Targeting Flashcards
Central banks’ focus on inflation comes from two fundamental observations regarding macroeconomic relationships: that high inflation is costly, and that monetary policy is the ultimate cause of sustained inflation.
- High inflation is costly
- Monetary policy is the ultimate cause of sustained inflation.
Examples of people or firms who suffer from high rates of inflation
For example, seniors whose pension incomes are not indexed to inflation suffer a reduction in their real incomes whenever inflation occurs.
Similarly, those who have made loans or purchased bonds with interest rates that are fixed in nominal terms lose because inflation erodes the real purchasing power of their financial investments.
High inflation also undermines the ability of the price system to provide accurate signals of changes in relative scarcity through changes in relative prices.
As a result, both producers and consumers may make mistakes regarding their own production and consumption decisions that they would not have made in the absence of high inflation.
Finally, the uncertainty generated by inflation is damaging to the economy in many ways.
When inflation is high, it tends to be quite volatile, and this volatility makes it difficult to predict the future course of prices.
As a result, periods of high inflation are often characterized as having much unexpected inflation.
The risk of unexpected inflation makes it difficult for firms to make long-range plans, and such plans are crucial when firms undertake costly investment and R&D activities in order to expand their production facilities or to invent and innovate new products and new production processes.
What is the result of high and uncertain inflation?
High and uncertain inflation reduces real incomes for many households and also hampers the ability of the price system both to allocate resources efficiently and to produce satisfactory rates of economic growth.
What do most economits and central bankers accept as the most important determinant of a country’s long-run rate of inflation
Most economists and central bankers accept the idea that monetary policy is the most important determinant of a country’s long-run rate of inflation.
When did the BoC begin inflation targeting? What is the process for maintaing this?
The Bank of Canada began inflation targeting in 1991 and has been doing so ever since.
Every five years, a formal agreement between the Government of Canada and the Bank of Canada is renewed, in which the Bank’s mandate and inflation target is clearly specified.
What is the targeted rate of CPI inflation?
The Bank’s current objective is to keep the rate of CPI inflation close to the 2 percent target.
Is the CPI inflation rate more or less volatile then the “core” inflation rate?
The CPI inflation rate is more volatile than the “core” inflation rate.
What is the core rate of inflation?
The core rate of inflation in Canada is the rate of change of a special price index constructed by removing some food items, energy, and the effects of indirect taxes from the overall Consumer Price Index.
How does the Bank of Canada keep the rate of inflation close to 2 percent?
In its efforts to do so the Bank closely monitors many aspects of the economy and anticipates changes in the levels of aggregate demand and aggregate supply.
In particular, the Bank monitors the output gap and the associated pressures that may be pushing inflation above or below the 2 percent target. Only then can it determine its appropriate policy actions.
How does the Bank, in the face of a persistan recessionay gap, attempt to close the output gap?
Faced with a persistent recessionary gap , which eventually tends to reduce inflation below the Bank’s 2 percent target, the Bank can pursue an expansionary monetary policy. By doing so, it can attempt to close the output gap and bring real GDP back to , keeping the inflation rate close to 2 percent.
What kind of policy does the Bank use in the face of a persistant inflationary gap?
Faced with a persistent inflationary gap , which tends to cause inflation to rise above the 2 percent target, the Bank can pursue a contractionary policy. By doing so, it can attempt to close the output gap and bring real GDP back toward and keep the inflation rate close to 2 percent.
What do persistant output gaps generally create?
Persistent output gaps generally create pressure for the rate of inflation to change.
To keep the rate of inflation close to the 2 percent target, the Bank of Canada closely monitors the output gap in the short run and designs its policy to keep real GDP close to potential output.
What combination is often refered to as the “divine coincidence” of inflation targeting?
For any central bank that is targeting inflation, its policies tend to stabilize both the rate of inflation and the path of real GDP—even though its formal mandate may not include targeting real output at all.
This combination is sometimes referred to as the “divine coincidence” of inflation targeting, and it comes from the fact that it is output gaps that create pressure for inflation to change.
What domino effect typically occures in the face of a positive shock?