Question

Suppose the current inflation rate is higher that the target inflation rate. Would the Central bank increase or decrease the interest rate? In your answer, explain how the Central bank makes this decision and explain the steps involved in changing the interest rate.

Answer 1

Inflation targeting is a monetary policy where the central bank sets a specific inflation rate as its goal. This targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability. The price stability can be achieved by controlling money supply. The monetary tools like open market operation and discount lending etc are used to maintain the inflation at the targeted rate.

The inflation targeting of the central bank depends upon the present economic situations of the economy. If the economy is in underemployment equilibrium the central bank target a higher inflation in order to promote growth. Once the fullemployment is achieved the central bank does not allow actual inflation moves above or below the targeted rate.

Whenever the actual inflation is above the targeted rate the central bank raise the interest rate though the contractionary monetary policy. For this the central banks uses the contractionary money supply tools like selling government securities in the open market, raising the discount rate, increasing reserve ration and increasing fed fund rate. Such an act will reduce the money supply and increase the interest rate. High interest rate increases the cost of borrowing and the borrowing for consumption and investment decreases. Thus a fall in aggregate demand reduces the price level to the targeted rate.