Question

Some economists argue the Federal Reserve should only focus on inflation targeting, rather than a broader set of policy objectives. Discuss both the potential advantages & disadvantages of inflation targeting.

Answer 1

The key responsibility of the Federal Reserve is to maintain stability in the economy by regulating the financial indicators. One of the major indicators of the economy is the inflation rate that reflects the health of an economy. Inflation targeting is a part of monetary policy where the central bank has an explicit target inflation rate which it aims to reach and maintain. Inflation-targeting has both advantages and disadvantages. These are described as follows.

Advantages

1. Expectations regarding the inflation rate remains in control. Therefore, with lower expectations, it is easier to maintain lower inflation rate.
2. Fluctuations in the economy decrease as the inflation rate becomes stable. Therefore, the economy moves toward stability.
3. Costs arising out of inflation like menu cost, shoe-leather cost, decreased value of money decreases.
4. It gets rid of ambiguity regarding policy measures.

Disadvantages

1. It sometimes become difficult to maintain the target in the face of economic instability. In such cases, the credibility of the economy and Fed are questioned.
2. The opportunity cost of maintaining the targeted inflation rate might be very high in terms of opportunity cost of other policies.
3. It restricts the Central Bank’s power and ability to implement strict policies.
4. There might be potential instability in case of a large supply shock.