Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Exerting Control over Inflation

By using monetary policy, the central bank is able to set the interest rate. The interest rate impacts on a number of macroeconomic variables, including the price level, output, unemployment, consumption, exchange rate and so on.

The big question is what the objective of monetary policy should be: to reduce unemployment, increase economic growth, support the exchange rate? And what problems are involved in achieving the stated aim?

Targeting inflation for price stability

The last few decades have seen a growing consensus among policy makers that the primary objective of monetary policy should be to control the rate of inflation (central banks often call this objective price stability). That’s not because policy makers don’t care about other macroeconomic variables, just that, in the long run, monetary policy is rather useless at influencing, say, economic growth or unemployment. Anyone who tries to use monetary policy to achieve objectives other than controlling inflation is likely to find themselves in hot water pretty

quickly. (You can read more about the dangers of using monetary policy to reduce unemployment in Chapter 12.)

The acceptance that monetary policy should be devoted to achieving price stability means that many central banks have adopted an explicit policy of inflation targeting, including the central banks of New Zealand, Chile, Canada, Israel, the UK, Sweden, Australia, Korea, Norway, the EU and the US. The latter was quite late to the party, only adopting an official inflation target in 2012, although unofficially economists understood that it had been targeting inflation for some time before then.

Inflation targeting involves announcing a target level (or range) of inflation that the central bank aims for. It then uses monetary policy to achieve (or attempt to achieve) the target level of inflation. The central bank must publicly announce the target and not keep it to itself, because doing so puts the bank’s reputation on the line and makes it more likely to hit the target. ( You can read more about an important debate related to this point [the rules versus discretion debate] in Chapter 13.)

In theory, inflation targeting should be pretty simple to implement:

Inflation above target: Raise the interest rate to reduce aggregate demand and reduce inflation.


Inflation below target: Lower the interest rate to boost aggregate demand and increase inflation.

As you can guess, however, in reality things aren’t quite so simple.