Discuss Advantages and Disadvantages of Inflation Targeting, with Special References to the Case of the Uk.

3333 Words Nov 21st, 2012 14 Pages
Discuss advantages and disadvantages of inflation targeting, with special references to the case of the UK.

1.0 Introduction: Prosperity, success and economic growth are largely perceived as created by free markets and private enterprise. However the need for government policy to promote economic growth as well as stability cannot be overlooked. Monetary policy has emerged as one of the most crucial government responsibilities this is due to a number of reasons. Firstly there is now a general agreement that low, stable inflation is important for growth and that ‘monetary policy is the most direct determinant of inflation’. Secondly monetary policy has ‘proven to be the most flexible instrument for achieving medium term stabilisation
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Furthermore in the long run the inflation rate is the only macroeconomic variable that monetary policy can affect. ▪ High rates of inflation are harmful to economic efficiency and growth. ▪ Inflation targeting serves as a ‘nominal anchor’ for monetary policy. It therefore provides a focus for the expectations of financial markets and the general public.[6]
2.1 Benefits of Inflation Targeting: Inflation targeting has several advantages, one being that it is easily understood by the public and thus highly transparent so inflation targeting enhances transparency. Following on from this having an explicit numerical target for inflation increases the accountability of the central bank, inflation targeting has the ability to reduce the likelihood that the central bank will fall into the time-inconsistency trap. Time inconsistency, ‘describes a situation where a decision-maker's preferences change over time, such that what is preferred at one point in time is inconsistent with what is preferred at another point in time’.[7] Time inconsistency forces the authorities in considering long term consequences of short term actions. This is because inflation targeting has the advantage of ‘focusing on what a central bank can do in the long-run i.e. control inflation rather than what it cannot