Many countries operate inflation targets. The number of countries with
explicit inflation targets increased almost sevenfold between 1990 and 1998
from 8 to 54. Since October
1992, the British Government has pursued an explicit inflation target for the
economy. When Labour came to power in May 1997, they set the target for RPIX
inflation at 2.5% (+ or - 1%) for the next five years.
of England Monetary Policy Committee sets interest rates with a view to
meeting the inflation target over the next two years. If
RPIX inflation moves 1% either side of the 2.5% target, the Governor of the
Bank has to write an open letter to the Chancellor explaining the reasons for
the inflation undershoot / overshoot and the steps the MPC are taking to
bring inflation within the target zone again.
Over the last seven years, RPIX inflation in the UK has stayed within
1% of the target measure. The 1990s has seen a return to the low, stable
inflation last seen in the 1960s.
OF AN INFLATION TARGET
effective inflation target can have several economic benefits:
It can reduce inflationary expectations if people believe a low
inflation target will be met. This will then reflect in the wage demands of
people in work. If employees expect low inflation they may be prepared to
accept a slower growth of pay. This reduces the risk of cost-push inflation
in the economy. A fall in inflation expectations can cause an inward shift of
the Phillips Curve.
A target gives monetary policy a clear anchor and improves the
accountability and transparency of economic policy-making. The quarterly Bank
of England Inflation Report is a highly detailed assessment of economic
trends and the Bank's best guess about future movements in inflation. All
A-Level Economists and Degree students should make a habit of reading it!
Sustained low inflation improves prospects for higher levels of
capital investment in both manufacturing an service industries. This is
because businesses will not demand such high nominal rates of return on
potential investment projects if they believe that inflation will remain low
A Bank of England report in August 1999 argued that inflation
targets have been successful in reducing inflation expectations and improving
people's understanding of the inflation process
DISADVANTAGES OF AN INFLATION TARGET
The main drawback is that a narrow inflation target is risky
for an open economy such as the UK. Am open economy relies heavily on exports
and imports and imposes few restrictions on free trade between countries.
Fluctuations in the exchange rate and changes in inflation
rates in other countries or in the prices of imported goods and services can
push the domestic inflation rate higher and lead to increases in interest
rates. Higher interest rates have the effect of damaging economic growth and
There is a danger that strict adherence to a tough inflation
target may lead to the economy operating well below its long-run productive
potential. This can create much higher unemployment - which in itself
generates economic and social costs.
most countries have decided that some target for inflation should be
maintained. How they achieve the target is a matter of continuous economic