Question

You are asked to advise a central bank of an advanced economy that is about to set an inflation target for the first time. Officials are leaning toward adopting a 2 percent target, in line with the practice in many other countries. Suggest two factors that the central bank should consider before settling on 2 percent?

Answer 1

The two factors to be considered are as follows:-

1) Relative purchasing power parity (RPPP) or consideration of foreign inflation

• As per RPPP, the exchange rate between currencies of two countries should encompass the effect of inflation. For example, if the exchange rate of INR 1= $70, this implies that inflation in US should be more to cover the effect of exchange rate with a view that purchase of products between both countries should be at par.
• While determining the inflation rate, central bank shall consider RPPP with countries it has major current and capital account transactions with.
• One of the benchmarks used in inflation targeting is Consumer Price Index (or CPI) which again leads us to purchasing price parity (PPP)
• High inflation rates can lead to devaluation of the countries' currency. Hence, understanding inflation with respect to exchange rates is important.
• Managing the inflation rate in this context helps to manage the exchange rate of the country so that is it well preserved from external shocks.

2) Macroeconomic factors

• Choice of index - there are various CPI index which are available. The choice of index is crucial in determining inflation range.
• GDP expectations - Inflation targeting impacts long term interest rate. Hence, central bank is required to make best estimate of future of the country's economy taking account of shocks as well. With the advent of inflation targeting, there will be scope to handle large shocks better.
• Financial markets - The efficiency of communication & information transfer between the financial markets and central bank will decide how successful inflation targeting has been. Understanding the relationship between financial and real sectors is important to access the projected impact.
• Reasons for inflation - Every economy is faced with challenges that lead to inflation. Understanding the same will help in determining the inflation rate. For example, agricultural economies like India are impacted by weather that determines productivity, GDP, prices and ultimately inflation in the country.