From Short to Medium Run (IS-LM-PC)

Inflation Targeting as a Policy Framework

coreExam · medium

Inflation targeting (IT) is a monetary-policy framework where the CB publicly commits to a numerical inflation target (typically 2%), has operational independence, and is transparent about its forecasts and reaction function. Adopted by ~40 countries since New Zealand (1990). Key benefits: anchored expectations, low average inflation, reduced sacrifice ratios.

Derivation

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The IT Framework

Four pillars:

Numerical target. Usually 2% inflation. Public and verifiable.
Independence. CB sets rates free of political influence.
Transparency. Publish forecasts, reaction function, minutes.
Accountability. Regular reporting to parliament and the public.

Strict vs Flexible IT

| Type | Loss function | Practice | |------|---------------|----------| | Strict | $(\pi - \pi^*)^2$ | Rare — would ignore real costs | | Flexible | $(\pi - \pi^*)^2 + \beta (Y - Y_n)^2$ | Near-universal in reality |

Even central banks with single-inflation mandates (ECB pre-2021) practise flexible IT implicitly.

Why IT Works

Anchoring $\pi^e$ at target makes the Phillips curve stable. Workers don't need to guess what future inflation will be — the CB has committed. Shocks move actual $\pi$ without lasting expectations drift. The sacrifice ratio falls.

Adoption Timeline

| Year | Country | |------|---------| | 1990 | New Zealand (first) | | 1991 | Canada | | 1992 | UK (after ERM exit) | | 1993 | Sweden | | 1999 | Eurozone (ECB, implicit) | | 2000s | Brazil, South Africa, Mexico, Chile |

Post-2008 Evolution

ZLB challenge. IT struggles when target is hard to reach from below. Japan's 2% target missed for decades.
Average inflation targeting (Fed 2020). Allows overshoots after undershoots.
Financial-stability mandate. Some CBs (ECB, Bank of England) now explicitly consider credit booms.

Despite criticism, IT remains the dominant framework for 30+ years.

Worked Example

Country A adopts IT with 2% target and publishes quarterly forecasts. Country B has no formal target.

Before IT: both countries had π ≈ 6% with high volatility.
After IT (A): πe anchors at 2% → wage contracts reflect 2% → π falls toward 2% with minimal u cost.
Country B: πe drifts with actual π; no anchor. π stays high or volatile.
After 10 years: A has π ≈ 2% with low σ(π). B still wrestling with inflation.

IT delivers low, stable inflation via credibility and anchored expectations — key empirical success of post-1990s macro policy.

Common Mistakes

—Confusing IT with a rigid rule — flexible IT (most real-world practice) responds to shocks.
—Assuming IT requires hitting the target exactly every period — it's medium-run average.
—Ignoring the ZLB challenge — IT struggles when the target is hard to reach from below.
—Thinking IT caused the Great Moderation single-handedly — globalisation and structural factors also helped.

Exam Cues

→IT framework: numerical target + independence + transparency + accountability.
→Strict vs flexible IT: most real-world CBs flexible.
→Key benefit: anchored expectations → low sacrifice ratio.
→Post-2008 debates: average IT, level targeting, financial-stability mandate.