Should Central Banks Be Targeting Inflation? Critical Thinking Samples

One of the key economic principles states that money tend to depreciate in value over time. On the one hand this principle is based on the fact that resources eventually rise in prices due to their scarcity and speculation-oriented market relations. On the other hand, the banking sector encourages money multiplication through borrowing operations. The faster money lose value the more unstable becomes the economy. Therefore mainstream economic theory suggests that inflation should be controlled. Many developed countries abuse monetary instruments through means of central banks to achieve the reasonable rate of inflation. This process is also called inflation targeting. The purpose of this paper is to assess whether the inflation targeting performed by central banks is efficient, and to present alternative opinion on this issue.
Monetary inflation targeting and its contemporary instruments. The fact that central bank is responsible for inflation containment seems logical enough as banking sector influences the level of money supply in the market. The target inflation is estimated by the government based on macroeconomic indicators and future expectations. Rowe (2010) in his work gives a detailed description of how the monetary mechanism of inflation targeting works: central bank raises interest rates on overnight loans in order to decrease the inflation rate and vice versa, the decrease of interbank rates stimulates inflation growth. In theory high interest rates lead to asset prices (securities, capital goods etc.) raise and consumption demand downfall which holds back the inflation growth rate.
Until 2008 the monetary policy was focused only on the instrument that regulated short-term interest rate. The present Chair of the Board of Governors of Federal Reserve System J. Yellen (2013) in her macroeconomic research implies the introduction of more flexible inflation targeting in US. In recent years the Federal Reserve System aims to regulate the long-term interest rates in order to influence market expectations more accurately. For instance, the quantitative easing (QE) program was aimed to reduce long-term interest rates and stimulate economic growth through government purchase of unreliable financial instruments from banks. The Federal Reserve policy has became more flexible due to improved communication with banking sector and timely adaptation to changes in macroeconomic dynamics. The goal-oriented policy has shifted its priority from blind inflation targeting to maintaining low unemployment level which is proved to be more realistic indicator of economic health. As a result, the US economy indicates the unemployment and inflation rates decrease with positive overall trend.
The downsides of monetary inflation targeting. Despite the improvements in monetary instruments to deal with inflation, its targeting through means of banking system proved to be not efficient enough in US, Canada, Japan and some countries of EU. Rochon (2010) in his paper researches the fiscal approach of post-Keynesian economic school. Post-Keynesians disclaim monetary measures on the basis of three postulates:
financial markets and production sector of economy are not as interlinked as monetarist have hoped.
central bank does not control money supply for every single economic group;
rate of interest and aggregate demand do not have direct correlation;
The consequences of the 2008 economic crisis proved that countries with enhanced industrial development dealt with recession more successfully than finance-led economies. The crisis itself was caused by the fact that financial markets created so much added value that it fell in deep disproportion with real production. Financial institutes should become less efficient in creation funds to evade just another financial collapse. Post-Keynesians stress that while monetary tools concentrated on the containment of inflation created by financial markets, no measures were taken to implement the adequate inflation regulating mechanisms in the considered to be vital manufacturing sector. Moreover, the inflation does no create as much economic instability as high rate of unemployment, bankruptcy and personal indebtedness (Chang, 2010).
The banking system does not control money supply in the light of production needs; it maintains the interest rate which is basically the price for borrowing costs. Therefore, higher interest rates stimulate the increase in rentier income, while discouraging production growth. The third postulate implies that inflation (regulated through interest rates) and demand (presumably influenced by inflation) are not interdependent in industrial and manufacturing economy. The prices in these industries are cost-driven, not demand-driven. Basically, the industrial production is more influenced by fluctuations of employees’ salaries and oil prices rather than changes in short-term interest rates. However, the entrepreneurs still require borrowing costs to invest in production and cover other needs of business. It seems that lowering the interest rates within monetary tools should encourage bank loans. The observation performed by Rochon (2010) confirms the opposite: the US banks despite extremely low interest rates have not increased their loan portfolio due to low creditworthy of borrowers and pessimistic market expectations during 2008-2011.

Conclusion

The vector of modern economy development indicates that the role of financial markets should be decreased in favor of production industry. In these circumstances the inflation targeting through banking system is proved to be less efficient as banks do not affect money supply directly, only generating additional money multiplication through a variety of financial instruments. Despite the introduction of new monetary measures, it appears that in order to reduce inflation rate the banking sector has to deflate the overall economic activity. Therefore the inflation targeting system requires reassessment considering the post-Keynesian fiscal approach. It seems that the synergy of monetary and fiscal instruments favoring the needs of real economy sector during decision-making process can result in more efficient inflation targeting and sustainable economic growth.

References

Rowe, N., Bougrine, H., & Seccareccia, M. (2010). Money, Central Banks, and Monetary Policy: The Path to Inflation Targeting. In Introducing macroeconomic analysis: Issues, questions, and competing views. Toronto: Montgomery Publications.
Rochon, L., Bougrine, H., & Seccareccia, M. (2010). Inflation Targeting: From Misconception to Misguided Policies. In Introducing macroeconomic analysis: Issues, questions, and competing views. Toronto: Montgomery Publications.
Yellen, J. (2013). Monetary Policy: Many Targets, Many Instruments. Where Do We Stand. “Rethinking Macro Policy II” a Conference Sponsored by the International Monetary Fund.
Chang, H. (2010). Greater macroeconomic stability has not made the world economy more stable. In 23 things they don't tell you about capitalism (p. 254). London: Penguin.