Editorials, GS-3, Indian Economy, Uncategorized

The currency question

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The recent agreement between the Government of India and the Reserve Bank of India to make inflation targeting the central bank’s prime focus has long way to go. This move represents an important structural shift in one of the two pillars of conventional macroeconomic policy (the other, of course, being fiscal policy).

Background:

Since the 1970s inflation targeting has become widely adopted by developed economies. Inflation targets were introduced to help reduce inflation expectations and help avoid high inflation which can destablise an economy. However, since the recession of 2008 and consequent prolonged unemployment, people have begun to question the importance attached to inflation target and are worried that a ‘religious’ commitment to low inflation is conflicting with other more important macro economic objectives.

What is inflation targeting?

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.

Why inflation targeting?

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. In general, a monetary policy framework provides a nominal anchor to the economy. A nominal anchor is a variable policymakers can use to tie down the price level. One nominal anchor central banks used in the past was a currency peg—which linked the value of the domestic currency to the value of the currency of a low-inflation country. But this approach meant that the country’s monetary policy was essentially that of the country to which it pegged, and it constrained the central bank’s ability to respond to such shocks as changes in the terms of trade or changes in the real interest rate. As a result, many countries began to adopt flexible exchange rates, which forced them to find a new anchor.

Many central banks then began targeting the growth of money supply to control inflation. This approach works if the central bank can control the money supply reasonably well and if money growth is stably related to inflation over time. Ultimately, monetary targeting had limited success because the demand for money became unstable—often because of innovations in the financial markets. As a result, many countries with flexible exchange rates began to target inflation more directly, based on their understanding of the links or “transmission mechanism” from the central bank’s policy instruments (such as interest rates) to inflation.

Why it is good?

  • 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.

Challenges to inflation targeting:

  • It puts too much weight on inflation relative to other goals. Central Banks Start to Ignore More Pressing Problems.
  • 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.

Way ahead:

Inflation targeting has been successfully practiced in a growing number of countries over the past 20 years, and many more countries are moving toward this framework. Over time, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances, including during the recent global financial crisis. Individual countries, however, must assess their economies to determine whether inflation targeting is appropriate for them or if it can be tailored to suit their needs. This should not be seen as a panacea for all the problems.

Conclusion:

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. There is a danger that Central Banks give too much weighting to low inflation, when there is a much more serious economic and social problem of unemployment. One solution would be to give an equal weighting to an inflation target and output gap target.

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