The Theory And Practice Of Inflation Targeting

On the monetary-policy operation, with the time going on, a growing consensus has emerged for price stability as the overriding, long-run ultimate goal of monetary policy. However, most of the debates focus on how to choose an immediate feasible target and obey a monetary-policy rule.In recent twenty years, there is an attractive breakthrough for the research of monetary policy rules in the literatures of monetary economics and monetary-policy analysis. Monetary-policy rule is a guide for monetary policy conduct and decision, which not only provides supports for the systematicness and scientificness of monetary-policy operation, but also enhances the transparency, credibility, robustness of monetary policy and the accountability of central banks. More important, the research on the optimal monetary-policy rule has become the objective reference to design the framework of monetary policy regimes and to estimate the effects of monetary policy.In addition, in practice, since 1990s, some central banks whether take rules into account much more with a minimal set of reforms, or set an explicit inflation rate as the nominal anchor, so as to keep the inflation low and stable around an appropriate level over time. Commonly, the inflation target has a specific horizon and a range or a point. The approaches by which central banks achieve the objective should be without any constraints. In another word, it is to make price stability as the primary objective for monetary policy to the central bank, which means that the central bank should behave according to the inflation stabilization rule. Inflation targeting was introduced in New Zealand in 1990 and has since been more and more popular around the world. This period of only 17 years has been major progress in practical monetary policy. But the effects are far from people's expectation. An inflation target is being used by an increasing number of countries to define the monetary framework. Not only 9 industrial countries, such as Canada, United Kingdom, New Zealand, Finland, Australia, Sweden, Spain, Iceland, Norway, but also about 16 emerging market countries, including Chile, Israel, Peru, Czech Republic, Colombia, Korea, Poland, Hungary, Mexico, Brazil, South Africa, Philippines, Indonesia, Thailand, Slovenia, Slovak Rep, Romania, adopt inflation targeting. There are so many countries have given up targeting exchange rate, monetary aggregate, or GDP and transferred to target inflation that the rapid and violent surge is beyond many economists' imaginations. In early 1990s, there wasn't any preceding specific academic research on inflation targeting. The credit for the initial rise of inflation targeting goes mostly to insightful central-bank and finance-department officials rather than academics. Once inflation targeting was introduced in the mid 1990s, there's an increasing number of academics started to do research on the topic, and by now there is large volume of accumulated research, and the member of papers and books on it is growing fast. Moreover, the good effects achieved by inflation targeting in practice give us a valuable research topic for the academics.Given that so many central banks have change to adopt inflation targeting, I think it is necessary to do some research on the new regime scientifically and systematically, including, how to define inflation targeting, how to understand its nature, as a new pattern of monetary regime, what differences between it with others. Why is an inflation targeting preferable to a fixed exchange rate or a stand-alone money growth target as the nominal anchor for monetary policy? Under what conditions can central banks adopt it successively? To China, as one of the developing countries, the People's Bank of China (PBC) conducts monetary policies discretionally in practice. The dual targets are monetary target and exchange target of Renminbi. The PBC attains them though the monetary base programming and foreign regulation respectively. There exist inherent conflicts between the two targets during the past several years in China, which changing the balance sheet of PBC and resulting more and more foreign reserves accumulate in the PBC. Can China deal with the problems by changing to adopt inflation targeting in the future? To seek these answers, this paper is organized as follows:Chapter 1 is the introduction of the whole paper. This part describes the research background, the significance of the paper, and the historical evolution of relative research literatures and so on. The methodology and main innovations of this paper are also introduced. So it becomes the start and the base of the research specified in the following sections.Chapter 2 focuses on the debates of the two theories of monetary-policy operation norm—discretion VS. rule, from which we can find the advantages of monetary-policy rules. Until 1980s, the discretion idea for monetary policy had been dominant in relative literatures. However, when the dynamic time -inconsistence problem was presented, the point that monetary policy should obey some rules seems to take the place of discretion in recent twenty years. Because discretion tends to cause the inflation bias, in order to eliminate the inflation bias and enhance the credibility of monetary policy, some kinds of incentive constraint mechanisms, such as reputation model, principal-agent approach and targeting regimes, can be introduced into the monetary-policy framework.Chapter 3 is dedicated to survey and discuss inflation targeting in the context of monetary policy rules. This section provides a general conceptual discussion of monetary policy rules, attempts to clarify the essential characteristics of inflation targeting. In the inflation targeting regime, central bank can use the inflation forecast as an intermediate objective of monetary policy. The public can monitor and evaluate inflation targeting by observing and scrutinizing the monetary authority's inflation forecast. Inflation targeting regime has a numerical inflation target, inflation report, inflation forecast and its models, a series of economic variables.Chapter 4 is dedicated to describe the mechanisms of inflation targeting in the closed-economy. It is argued that inflation targeting is best understood as a commitment to a targeting rule. Targeting rules allow the use of judgement and extra model information, and they can nevertheless bring the economy close to the socially optimal equilibrium.Chapter 5 extends previous analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand with some microfoundations, and with stylized realistic lags in the different transmission channels for monetary policy. This section compares targeting of CPI and Domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions and the Taylor rule. The optimal monetary policy response to several different shocks is examined. Flexible CPI-inflation targeting stands out as successful in limiting not only the variability of CPI inflation but also the variability of the productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model gives limited support for a so-called monetary conditions index, MCI.Chapter 6 changes to review the recent international experiences of inflation targeting. This chapter classifies countries that define their monetary policy framework by an inflation target into full-fledged inflation targeters, eclectic inflation targeters and inflation targeting lite regimes. This classification is based on indicators of the clarity and credibility of the commitment to the inflation target. The three regimes can be viewed as corresponding to different welfare maximizing combinations of policy objectives, each conditional on a country's "endowed" level of credibility. The credibility of the regimes is related empirically to structural differences. Policy implications are drawn, especially for merging market countries aiming at full-fledged inflation targeting.Chapter 7 examines the international experience with full-fledged inflation targeting monetary regimes. Stylized facts are brought together from a review of the institutional elements of inflation targeting frameworks, a comparison of actual and targeted inflation outcomes, and case studies of large inflation target misses. Inflation targets are missed about 40percent of the time and often by substantial amounts and for prolonged periods, yet no country has dropped inflation targeting. The resilience of the inflation targeting regime is attributable to the flexibility of the framework, its high standards of transparency and accountability, and the lack of realistic alternatives.Chapter 8 studies whether or not China should adopt inflation targeting as soon as possible. As China economy becomes more market based and continues its rapid integration into the global economy, having an independent and effective monetary policy regime oriented to domestic objectives will become increasingly important. Given the current underdeveloped state of the Chinese banking and financial systems, China still has not satisfied the requirements needed for inflation targeting. So the paper is not advocating a full-fledged inflation targeting regime to China, although this could serve as a useful long-term goal. However, I recommend an explicit low long-run inflation objective, operational independence for the PBC with formal strategic guidance from the government, and a minimal set of financial sector reforms to make the Chinese banking system robust against interest rate fluctuations. Anchoring monetary policy with an explicit inflation objective would be the most reliable way for the PBC to tie down inflation expectations and thereby enable monetary policy to make the best contribution to macroeconomic and financial stability, as well as economic growth.