Inflation Targeting: A Review of the Issues

Máiréad Devine and Daniel McCoy
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Máiréad Devine: Central Bank and Financial Services Authority of Ireland
Daniel McCoy: Central Bank and Financial Services Authority of Ireland

No 5/RT/97, Research Technical Papers from Central Bank of Ireland

Abstract: The European Monetary Institute have narrowed down the choice of candidate strategies for a single monetary policy within European Monetary Union to inflation targets or monetary aggregate targets. In practice it is unlikely to be a simple choice between these targets, since all monetary authorities that currently pursue either of these strategies also monitor a wide set of economic and financial variables to inform monetary policy. The choice of target will indicate more about the style of monetary policymaking. This paper focuses on inflation targets which have come to prominence internationally over the last decade. It examines both the theoretical and operational issues arising from the use of inflation targets as part of monetary policy. The theoretical aspects of inflation targeting are developed in a model which uses inflation forecasts explicitly as an intermediate target. These inflation targets provide a guide to policymakers by increasing the ability to establish credibility and commitment to overcome the problem of inflation bias inherent with discretionary monetary policy. The operational aspects of inflation targets stress the role of (i) deciding on the ultimate objective, either price stability solely or in addition to an output goal, (ii) the independence of the monetary authority from political interference, (iii) setting the inflation target value, either for inflation or the price level, (iv) choosing the appropriate time horizon, (v) the choice of instruments to achieve the target and so on. The experiences of those countries that have adopted inflation targets is drawn upon. While this experience has tended to be quite positive, the timespan since their adoption is too short for a conclusive assessment. The decision on whether inflation targeting will eclipse monetary aggregates as the dominant monetary policy strategy will depend on the accuracy of inflation forecasting compared with the predictability of money demand.

Pages: 44 pages
Date: 1997-10
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