The move to inflation targeting

Pages24-25

Page 24

CENTRAL BANKS don't have it easy. Many of them are committed by law to achieving price stability-that is, ensuring that the rate at which price levels change is low and steady. Price instability causes uncertainty, distorting economic decision making and hampering economic growth. More often than not, the instability is the result of inflation-a persistent rise in the price level typically measured by the consumer price index (an indicator that measures the change in the cost of a basket of products and services, including housing, electricity, food, and transportation). Deflation-a persistent fall in the price level-has been rare since World War II, although it has recently resurfaced as a growing threat.

What causes inflation? Typically, it is excessive liquidity- that is, too much money chasing too few goods. Allowing more money to circulate induces people to increase their demand for goods and services. If this increased demand is not matched by an increase in output, prices are bid up. This relationship is best explained by the Equation of Exchange, developed by a nineteenth-century U.S. economist, Irving Fisher. Fisher's equation, MV= PQ, states that M (the money supply) multiplied by V (the velocity of money or the number of times the stock of money is turned over during a given period to finance spending on final goods and services) is equal to P (the price level) multiplied by Q (the quantity of the final output of goods and services). Since the velocity of money, V, is fairly stable, an increase in the supply of money, M,usually results in an increase in total spending. If M is increased in the short term, there is usually a corresponding increase in the price level, P, assuming that output, Q, cannot be increased in the short term. As a result, a short-term increase in the money supply will push prices up.

This formula suggests that central banks can influence the rate of inflation by changing the rate of growth of the money supply through monetary policy instruments. To do this, they can engage in open-market operations (buying and selling government securities) to achieve a targeted level of short-term interest rates, or set the discount rate (the rate at which the central bank lends money to commercial banks) directly. When they sell government securities (that is, when people purchase, for example, treasury bills), the supply of money available in the...

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