Explained: What is inflation targeting and how does it help an economy?

Updated : April 02, 2021 08:06 AM IST

Inflation targeting works as it prompts consumers to expect a rise in prices in the future

The policy allows the central bank to respond against changes in the domestic economy

The strategy is based on the belief that long-term economic growth is best achieved by maintaining price stability

India has retained Reserve Bank Of India's (RBI's) retail inflation target band of 2-6 percent under the 'Flexible Inflation Targeting' framework. At present, the RBI has a target for retail inflation or CPI of 4 percent with a margin of 2 percent on either side. The move comes despite Moody's Analytics stating that India's inflation is at an "uncomfortably high" level. Here is a look at the policy of inflation targeting, that too a large extent is the backbone of India's economy.

What is inflation targeting

Inflation targeting is a policy followed by the central regulator in the monetary policy and is adjusted to achieve a specified annual rate of inflation. The strategy is based on the belief that long-term economic growth is best achieved by maintaining price stability that can be achieved by controlling inflation.

Origin of inflation targeting

The policy owes its origin to Germany and Switzerland. In the 70s, the two countries adopted the strategy to counter hyperinflation following the collapse of the Bretton Woods International Monetary System.

Inflation targeting works as it prompts consumers to expect a rise in prices in the future. This in turn, leads to a phenomenon where both the consumer and traders will try to buy more of the products at present to counter the future rise in price. This leads to an increase in demand stimulating economic growth.

The central bank -- the regulator -- will employ all tools that are available to it for this purpose ranging from open market operations to discount lending. Another method used by the central banks for inflation targeting is increasing and decreasing interest rates. The central bank will raise interest rates to slow inflation in order to slow the economic growth whereas the interest rates are decreased to boost inflation and economic growth.

Merits and demerits of inflation targeting

There are several merits of this policy. Firstly such a policy allows the central bank to respond against changes in the domestic economy. This in turn brings stability to inflation levels leading to a stable economy and investment environment.

However, detractors of the policy argue that it creates a condition suitable for unsustainable speculative bubbles paving the way to economic disasters. Critics also claim that it encourages inadequate responses to terms-of-trade shocks or supply shocks.

With inputs from agencies.

Published : April 01, 2021 11:24 PM IST

Explained: What is inflation targeting and how does it help an economy?

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