ESSAY: evaluate whether a central bank such as the federal reserve should always prioritise meeting their inflation target

Question 1

Definitions of inflation target??

Answer 1

Often the primary objective of the central bank, the inflation target is an annual target that the country wants to meet for the average increase in the prices of goods

Question 2

Why the central bank should prioritise meeting the inflation target?

Answer 2

• Inflation is an important factor in determining confidence in the economy, and central banks have the best monetary tools to influence the inflation target
• if they allow inflation to get out of hand, they could see a fall in the standards of living of people in the country if rising prices aren’t matched by rising wages
• inflation can also reduce a countries competitiveness as the products get more expensive, which can lead to balance of payment problems as well as AD reduction
• deflation is a sign of a country not doing well, so its important that the bank uses QE to buy government bonds and give banks more money to lend out, increasing the money supply. if the bank ignored this then there could be a recession which can ruin a countries economy and confidence levels, also leading to reductions in FDI
• a stable inflation rate increases confidence and makes it easier for businesses to plan ahead

Question 3

Why a central bank may choose not to prioritise the inflation target??

Answer 3

• if the bank is choosing to increase interest rates to curtail inflation (deflationary monetary policy) It might have adverse effects on the economy and discourage spending more than expected eg the reverse of the accelerator theory so businesses invest less
• sticking so tightly to the inflation rate can see other economic policies not being achieved ie increasing interest rate to slow down inflation will see an inflow into the economy of foreign money, increasing the value of our currency and making us less competitiveness, worsening balance of payment problems and possibly causing a recession
• sometimes slightly higher inflation is a good sign of economic growth and therefore shouldnt be dealt with heavily
• sometimes deflation represents increases in our LRAS and as long as business and consumer confidence stays high, it may not be a bad thing to allow in the short term

Question 4

What it depends on ??

Answer 4

• depends on the state of the economy, if inflation is naturally low then the bank may be wasting time and resources achieving something that will happen naturally
• how much the rate is fluctuating from the target and the causes for this
• the importance of other macroeconomic objectives of the government; if the bank prioritises the interest rate then the government can work towards the rest of the policies it needs to achieve
• type of inflation, monetary policy more effective for demand pull but not cost push