Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. It will have price stability as the main goal of monetary policy.
Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another, presumably stable, currency.
Pros :
- It will lead to increased transparency and accountability.
- Policy will be linked to medium/long term goals, but with some short term flexibility.
- With inflation targeting in place, people will tend to have low inflation expectations. If there was no inflation target, people could have higher inflation expectations, encouraging workers to demand higher wages and firms to put up prices.
- It also helps in avoiding boom and bust cycles.
- If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. This can also be avoided with targeting.
- Inflation targets can have various benefits, especially during ‘normal’ economic circumstances. However, the prolonged recession since the credit crunch of 2008 has severely tested the usefulness of inflation targets
Cons :
- It puts too much weight on inflation relative to other goals. Central Banks Start to Ignore More Pressing Problems like unemployment.
- Inflation target reduces “flexibility”. It has the potential to constrain policy in some circumstances in which it would not be desirable to do so.
- Cost-push inflation may cause a temporary blip in inflation.
- It cannot help remove supply bottlenecks and shortages
- It cannot help external shocks, exchange rate might suffer in the short run
- Growth and employment might take hits in the short run
