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Inflation Targeting

Inflation Targeting

Imagine you woke up and found out that there was an increase of 20% on all prices at your local grocery store. Although this may sound unlikely to happen, many countries experienced such inflation levels in very short periods of time.

How do governments keep hyperinflation at bay? Why do governments have a targeted inflation rate? What would happen if the inflation rate was allowed to rise to very high levels?

This article will help you learn everything you need to know about inflation targeting and why it is such an important issue.

Inflation Targeting Definition

Inflation is defined as the rise in the general level of prices. This means that the purchasing power of money is decreasing, requiring more units of money to purchase the same goods and services. Although this may sound bad, some inflation is actually desirable. A relatively small increase in the general price level indicates that money is being spent. Frequently, inflation occurs due to increased aggregate demand or spending in an economy. If inflation is too low, it indicates little spending in the economy.

However, too much inflation is a problem. When inflation is higher than expected, it indicates a widespread decrease in real income, which is income adjusted for inflation, a measure of purchasing power. When consumers and businesses struggle to maintain their everyday purchases at the new higher prices, they may be tempted to borrow money just to maintain their purchasing power. This could cause the economy to overheat and spiral into hyperinflation.

Instead, the central bank tries to discourage borrowing and motivate consumers and businesses to instead scale back their spending. It does this by raising interest rates. Scaling back in consumer spending and business spending reduces aggregate demand, and GDP, and allows prices to stabilize.

Curbing spending in an economy is a risky business. The goal is to reduce increases in spending so as to stabilize prices without triggering a recession, which is a decline in national output--real gross domestic product, or real GDP. A recession will likely increase unemployment as businesses lay off workers in response to the decline in revenues.

Therefore, it is in policymakers' best interest to ensure that inflation is above zero but not too high.

Inflation targeting is when a central bank sets a desired inflation rate (usually 1-3%) and uses monetary policy to achieve it.

Inflation Targeting Policy Applications

Inflation targeting policies are used to maintain economic stability and avoid the extremes of the economy overheating or falling into recession.

By limiting inflation to a target rate, the central bank can prevent runaway inflation, also known as hyperinflation. An inflation target requires that the government actively monitor inflation and compare it to the target, reacting swiftly whenever it deviates. If inflation is too high, the central bank will raise interest rates so that consumers and businesses will cut their spending.

However, if the policy is too effective, the increase in interest rates can trigger a widespread reduction in spending that results in business losses, lower GDP, and higher unemployment--in short, economic recession. This is not a good outcome either. Thus, another primary policy use of inflation targeting by the central bank is to avoid a recession that raises the unemployment level.

As such, the central bank must make sure there is some inflation but not too much. The long-term inflation rate target in the U.S. is currently 2%, meaning that the price level should increase about two percentage points annually. This signals a healthy level of spending that will make consumers and producers optimistic about the future.

Examples of Inflation Targeting

Typically, inflation targeting is part of monetary policy relating to the money supply, and it is conducted by a nation's central bank. The United States central bank, the Federal Reserve System, adjusts the money supply to try and maintain both an interest rate target and an inflation rate target.

It wasn't until 2012 that the Fed decided to pursue inflation-targeting policy, in which they set the desired inflation rate at 2%. Before using inflation targeting, the Fed was using the Taylor rule, which looks at historical inflation and builds monetary policy according to past experience. In contrast, inflation targeting looks forward to future inflation and conducts monetary policy accordingly. It is also more transparent for consumers to understand if the policy is to prevent inflation from going above 2%.

Some other countries that also pursue inflation targeting policies include the United Kingdom and New Zealand.

Benefits of Inflation Targeting

The purpose of inflation targeting is that the government has a better chance of preventing severe outcomes--like the economy overheating or falling into recession. A policy of inflation targeting has several other benefits too.

Inflation targeting increases transparency and reduces uncertainty in the market. When investors are well aware of an inflation target of 2%, they can better plan their portfolios and have an increased incentive to invest. If investors weren't clear about where inflation was heading, and there was uncertainty in the markets, investors would be less willing to invest their money. This, in turn, would lower investment spending, and economic output would fall.

An inflation-targeting policy forces accountability, because everyone knows the inflation target and the actual inflation level. Any deviation from the target should be met with a proper response from the central bank. If it is not, then voters in a democratic society can hold their government responsible.

Knowing the policy and seeing proper steps being taken can be reassuring to the public and help to maintain consumer and investor confidence. This can bolster faith in the institution and in continued economic growth.

Inflation targeting Zimbabwe currency 2008 StudySmarterZimbabwe currency 2008, Wikimedia Commons

The image above shows the Zimbabwe currency during 2008 after having experienced hyperinflation. The government had to print up to a hundred billion dollar notes to cover the severe increase in price levels.

Having an inflation target can encourage wiser government spending by reminding policymakers that excessive increases in government spending, or excessive tax cuts, can unacceptably trigger inflation. When unemployment is high, policymakers may want to use aggressive fiscal policy actions, such as increased government spending to boost aggregate demand and reduce unemployment. Additionally, maintaining an inflation target will force policymakers to search for more measured responses, such as encouraging business investment, than a spending bonanza.

Challenges of Inflation Targeting

Unfortunately, inflation is difficult to control! A central bank can directly control the money supply and interest rates, but it can't directly control inflation. Aggregate demand can be driven by factors that are outside of the government's control.

Post-Covid consumer demand in the U.S. has been very high. Global supply chain issues have further exacerbated the situation, causing inflation in the U.S. to increase beyond the 2% target in 2022, despite government efforts.

Another big challenge is what economists call "sticky prices" and "sticky wages." Although prices rise quickly when demand is high, when aggregate demand decreases, sellers naturally resist lowering prices. High prices tend to be "sticky" in the sense that they get stuck up high! Then don't easily come back down again. While the government is trying to reduce inflation, sellers across the market may actually be “locking in” the inflated prices.

In a similar way, wages are particularly slow to adjust to market forces as prices are rising. This is because business owners tend to reap the additional profits instead of raising wages. Eventually, laborers are forced to demand an increase in pay so as to keep up with rising prices! Nevertheless, wages have a tendency not to increase except under duress. This is what economists call stickiness. Prices are sticky in the downward direction, and wages are sticky in the upward direction.

Another reason inflation is difficult to control is future expectations about price levels. When consumers and businesses anticipate excessive demand, they often increase their spending to buy goods and services before prices rise further. This is the demand determinant known as the expectation of future prices. Demand actually increases today when buyers assume that prices will increase in the future. If the central bank succeeds in curbing spending and prices start to come back down, that may cause consumption to pick up again, driving inflation back up.

Inflation Targeting - Key Takeaways

  • Inflation targeting is when a central bank sets a desired inflation rate (usually 1-3%) and uses monetary policy to achieve it.
  • Inflation targeting policies help maintain economic stability and avoid excessive inflation.
  • The benefits of inflation targeting are policy transparency and central bank accountability.
  • Limiting inflation is made difficult by the natural tendency of prices and wages to be sticky.

Frequently Asked Questions about Inflation Targeting

Inflation targeting is the term for the government setting the desired inflation rate and using fiscal and monetary policy to achieve it.

An example of inflation targeting would be when the Fed in the US increases the interest rate in order to keep inflation at a desirable rate. 

Inflation targeting policies are used to maintain economic stability and avoid triggering hyperinflation or economic recession.

Benefits of having a policy of inflation targeting include transparency and accountability. Stating the desired or acceptable level of inflation informs the general public both on what the central bank is trying to do, and also on how well it is succeeding at maintaining the targeted inflation rate.

Limiting inflation is made difficult by the natural tendency of prices and wages to be sticky.

Final Inflation Targeting Quiz

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What is inflation targeting?

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Inflation targeting is the term for the government setting the desired inflation rate and using fiscal and monetary policy to achieve it.

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What is an example of inflation targeting?

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One example of inflation targeting is the U.S. Federal Reserve's policy of keeping inflation at 2%. 

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Why are inflation targeting policies used?


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Inflation targeting policies are used to maintain price stability. They attempt to avoid hyperinflation while also avoiding triggering an economic recession.

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What are the benefits of using inflation targeting?

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Benefits of an inflation targeting policy include increased transparency, reduced uncertainty, and increased accountability. When everyone knows the target inflation rate and observes the central bank taking steps to curb inflation, it helps restore consumer confidence. And if proper steps are not taken, the government can be held accountable.

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What are constraints with inflation targeting?


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Limiting inflation is made difficult by the natural tendency of prices and wages to be sticky. Another challenge is that some factors can cause persistent inflation independent of monetary policy.

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What is inflation?

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Inflation is defined as a rise in the general level of prices. 

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What happens when an economy experiences high inflation levels?

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When inflation is higher than expected, it indicates a widespread decrease in real income or the ability of one's income to purchase things. 

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Explain how high inflation leads to lower economic growth.

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If inflation gets out of control, it can lead to the same problems as with low inflation. It can actually trigger a recession due to the widespread decrease in real income, which is a measure of purchasing power. If the expectation is that prices will continue to increase, consumers have an incentive to spend more now, before prices rise even further. The extreme uncertainty in the market will cause investors to remove their money, which likely triggers a market crash and a recession.

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Which institution is responsible for inflation targeting policies?

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Typically, inflation targeting is more of a monetary policy relating to money supply and is conducted by a nation's central bank. The United States central bank, the Federal Reserve System, adjusts the money supply to try and maintain an inflation rate target. 

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What is a primary use of inflation targeting policies?

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A primary policy use of inflation targeting is to avoid the economy overheating or slipping into recession.

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What is the long term inflation rate target in the US?

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 The long-term inflation rate target is roughly 2 percent, meaning that the price level will increase about two percentage points annually. 

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Explain how reducing uncertainty in the market through inflation targeting benefits the economy.

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When investors are well aware of inflation expectations, they can better plan their portfolios and have the incentive to invest. If investors weren't clear about where inflation was heading, and there was uncertainty in the markets, they would be less willing to invest their money. This, in turn, would lower investment spending, and economic output would fall.

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What would happen if there wasn't an inflation target?

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Without an inflation target, policymakers would easily ignore inflation until it had become excessive and difficult to control. The inflation target forces accountability, and also reassures the public, and helps maintain consumer and investor confidence. 

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Explain how sticky prices provide a challenge for inflation targeting.

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Sellers naturally resist lowering prices, even during recessions. However, during a booming economy, sellers will likely increase prices as much as possible until they risk reduced sales. Therefore, while the government may actively be trying to reduce inflation, sellers across the market will likely resist lowering their prices, “locking in” inflation.

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Explain how future expectations about price levels provide a challenge for inflation targeting.

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When consumers and businesses anticipate excessive demand, they often increase their spending to buy goods and services before prices rise further. This is the demand determinant known as the expectation of future prices. Demand actually increases today when buyers assume that prices will increase in the future.

Consumers and businesses can complicate government efforts to set an inflation target by not buying when the government wants. When inflation is rising, consumption may increase to try to “buy while it’s still cheap.”  When inflation begins to fall at first, consumption may pick up again in anticipation of falling prices, driving inflation back up.  

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What is the inflation rate target that most central banks aim for?

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1-3%

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True or False: Small inflation is preferable to no inflation.

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True

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Purchasing power _____ with a(n) ______ in inflation.

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decreases; increase

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What type of relationship do purchasing power and inflation have?

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Inverse

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The Federal Reserve will ______ interest rates during inflation.

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Raise

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Raising interest rates causes aggregate demand to _______ and GDP to _______

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decrease; decrease

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Curbing inflation in the economy is difficult because...

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It can push the economy into a recession

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The Federal Reserve will _____ interest rates during a recession

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Lower

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Lowering interest rates causes aggregate demand to ______ and GDP to _______

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Increase; increase

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What was the Fed using before inflation targetting?

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Taylor rule

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The benefits of inflation targeting is increased ________ and ______ in the economy

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transparency; stability

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True or False: The current inflation target for the U.S. is 4%

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False

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True or False: Inflation targetting lacks accountability.

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False

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A central bank can control ______ and _____

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money supply; interest rate

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True or False: The Fed can directly control inflation.

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False

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Prices are sticky in the ______ direction; wages are sticky in the _____ direction.

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Downward; upward

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True or False: Price expectations are problematic when targetting inflation.

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True

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Rapidly increasing prices are known as....

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Hyperinflation

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Decreasing prices are known as...

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Deflation

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True or False: Central banks should discourage spending if inflation is rising.

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True

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