Video Transcript: Lesson 27

Continuing in Unit Nine, we'll discuss Lesson Three: Inflation Targeting. We want to find out how do we actually target inflation. So, a policy called inflation  targeting. Some central banks use their tools to set the inflation rate as close as  possible to a target, just as we know that a monetary authority cannot literally  control interest rates, we know it cannot literally set the inflation rate either.  Right. So rather, it can use the policy tools at its disposal to influence the  economy and attempt to reach the target inflation rate. In its simplest form, the  target is some publicly announced inflation rate or figure, say 3% If the monetary authority or the central bank thinks the inflation rate is likely to be higher than  3% for the year, it adopts a contractionary monetary policy to reduce the inflation rate. So contractionary, they want to contract the money supply, potentially raise  interest rates. They want to make you know inflation come down. They want to  bring asset prices down. They want to cool off the economy. So they'll use a  contractionary monetary policy, right? They want to curb inflation to be 3% or  less, right? If it thinks that the inflation rate is likely to be lower than the target, it  adopts an expansionary policy. Expansionary policy again: lower interest rates,  you know, higher money supply into the market, and more bank lending. So this  will ramp up expansion and growth inside the market. So this will be an  expansionary policy. Inflation is the world is in this world. So inflation is  predictable, right? One argument often heard is that deflation or negative  inflation is problematic too. From a historical perspective, prolonged period of  deflation in the United States occurred during the Great Depression. It also  coincided with a negative output growth, right? So major contraction in the  economy. More recently, Japan experienced both slow real gross domestic  product and some periods of deflation during the 1990s. Many policymakers  have apparently concluded that deflation is to be avoided because it could  possibly underlie a depression because of historical measures. An alternative  possibility is that deflation is correlated with periods of low economic activity, but  it is unclear whether it is the cause or the consequence of a sluggish economy.  Whatever the connection between deflation and depression, the prevailing  wisdom of the Fed and other central banks is to avoid deflation, given that the  central banks cannot always hit their targets precisely. Aiming for zero inflation  makes deflation more likely than when central banks adopt a target with positive inflation. Some inflation may make it easier for relative prices and wages to  adjust in the economy if the demand for beef decreases and the demand for  pork increases, then the price of beef should decrease relative to the price of  pork, and the price of pork would increase. Such adjustment is therefore  straightforward. Let's use similar logic now, saying that if the demand for  accounts decreases and the demand for systems analysis increases, then the  wage of accounts should decrease and the wage of systems analysts should  increase. Right? This may be more problematic. People typically respond very  negatively if there's an attempt to cut their wages, it may be easier for employers

to let inflation do the job of reducing the real wage instead. A second issue is  whether the inflation target should be allowed to vary. Instead of announcing a  3% target for all times, the monetary authority might decide that the target rate  should depend on the state of the economy. For example, they could have a  higher target rate in recession and a lower target rate in booms. This way,  monetary policy could still be used to help keep the economy at potential max  output. Now, finally, there's a question of punishment for missing a target. If the  purpose of inflation targeting is to support a particular or a moderate inflation  rate, such as 3% then a central banker missing the target ought to be fined or  even terminated, just like a manager of a store who. Consistently misses sales  targets. They should be handled one and the same. They don't make a inflation  target and then miss that target. They should be handled similarly as someone  that is operating a business, that is managing a business. Presumably, if a  central bank has goals to achieve, it should also have incentives to meet those  goals. Central bankers are often called to testify in front of bodies such as the  U.S. Congress, who monitor the progress of the economy relative to particular  targets.