For more than two decades has inflation targeting been shaping monetary policy. Inflation has successfully been brought down and stabilized. However, financial imbalances have arisen at the same time, resulting in the Great Recession that major economies are still struggling with. Monetary policy seems to have been overemphasizing price stability while underestimating the risks of financial imbalances. Even before the crisis did research point to this problem, but – as history teaches us – it does usually take events with major impact on the understanding of the economy for these to be decisively addressed. It seems legitimate to argue that the Great Recession is such an event. It is therefore of great importance to analyze possible consequences concerning monetary policy and inflation targeting in particular.
The first section gives a brief history of monetary policy that shows how it has evolved over time and how economic events initiated major changes. Section 2 presents the concept of inflation targeting and how the lessons of history have been implemented into this policy framework. Section 3 discusses the shortcomings of inflation targeting that were revealed by the Great Recession and introduces several suggestions for modification that address these shortcomings
Table of Contents
Introduction
1. A brief history of monetary policy
2. Monetary policy today
3. Challenges of the 21st century
4. Conclusion
Research Objectives and Themes
This paper examines the evolution and current limitations of inflation targeting as a central pillar of monetary policy, particularly in light of the global financial imbalances exposed by the Great Recession. It investigates whether the traditional focus on price stability has led central banks to neglect financial stability and discusses potential modifications to the existing policy framework.
- Historical development of monetary policy and its conceptual milestones.
- The framework of inflation targeting and its core components.
- Shortcomings of contemporary monetary policy regarding financial market imbalances.
- Proposals for new policy tools and updated macroeconomic objectives.
Excerpt from the Book
3. Challenges of the 21st century
Inflation targeting seems to have been very successful since it was formally adopted for the first time by the central bank of New Zealand in 1990. Ever since, inflation has remained remarkably low and stable. However, at the same time the occurrence of financial crises, e.g. in Scandinavia, East Asia, Japan or the most recent financial crisis of 2008, has been accelerating. It seems that one “villain”, i.e. inflation, gave way for a new one, namely financial instability (Borio and White, 2004).
Figure 1 presents the gist of the “Great Liquidity Expansion puzzle” for the Euro Area. How can inflation stay at such low rates despite this large expansion of liquidity and credit? (Figure 1 represents inflation, liquidity and credit by the Harmonized Index of Consumer Prices for the Euro Area, M3 as reported by the European Central Bank and credit given by the banking sector to domestic governments and residents, respectively, indexed to 1998). Borio (2006) concludes that the liberalisation of the financial sector, successful anchoring of inflation expectations and increased price-competition due to globalisation have led to a change in the dynamics of the economy. In his opinion the main risk today that economic policy has to tackle lies not in inflation, but rather in financial imbalances. The Great Recession that still continues to reveal these imbalances, especially in the Euro Area, seems to confirm Borio’s view.
Summary of Chapters
Introduction: Provides an overview of how inflation targeting has influenced monetary policy and identifies the Great Recession as a catalyst for questioning its current dominance.
1. A brief history of monetary policy: Traces the evolution of central banking through various economic eras, from the gold standard to the rational expectations revolution of the late 20th century.
2. Monetary policy today: Defines the current framework of inflation targeting, focusing on the combination of policy rules and communication strategies to manage public expectations.
3. Challenges of the 21st century: Analyzes the emergence of financial instability despite low inflation and discusses the insufficiency of using only the policy rate to address structural imbalances.
4. Conclusion: Summarizes the need for central banks to adopt new tools and broaden their objectives beyond mere price stability to include financial sector stability.
Keywords
Monetary Policy, Inflation Targeting, Great Recession, Financial Imbalances, Price Stability, Central Banking, Interest Rates, Great Moderation, Macroeconomics, Liquidity, Credit Growth, Economic History, Financial Stability.
Frequently Asked Questions
What is the primary focus of this paper?
The paper examines the effectiveness of inflation targeting as a central monetary policy strategy and evaluates why it failed to prevent the financial imbalances that led to the Great Recession.
What are the main thematic areas covered?
Key areas include the historical evolution of central bank practices, the concept of inflation targeting, the "Great Liquidity Expansion puzzle," and the need for new regulatory tools in the 21st century.
What is the central research question?
The research asks whether inflation targeting has overemphasized price stability at the expense of ignoring systemic financial risks, and how monetary policy should be modified to address these failures.
Which scientific methods are employed?
The author utilizes a historical and theoretical review of existing macroeconomic literature, combined with the analysis of economic data and charts regarding inflation, liquidity, and credit growth.
What does the main body of the text discuss?
It covers the history of monetary regimes, the mechanics of inflation targeting (deed vs. word components), the shortcomings revealed by the 2008 crisis, and proposed policy expansions.
What keywords define this work?
Essential terms include Monetary Policy, Inflation Targeting, Financial Imbalances, Great Recession, and Central Bank Independence.
How did the gold standard affect monetary policy in the early 20th century?
The gold standard restricted the ability of central banks to pursue domestic stabilization, as policy was primarily focused on maintaining fixed currency values, which contributed to poor responses during the 1920s and 1930s.
What is the "impossible trinity" mentioned in the text?
Coined by Robert Mundell, it refers to the incompatibility of maintaining a fixed exchange rate, allowing free capital flow, and conducting an independent monetary policy simultaneously.
Why is the "Great Moderation" considered a double-edged sword?
While the period saw low inflation and stable output, it also lulled policymakers into a false sense of security, causing them to underestimate the rising risks of financial instability.
What role does regulation play in the author's suggestions for future policy?
The author suggests that since the policy interest rate is an insufficient tool for addressing financial imbalances, supplemental regulatory tools (such as leverage or capital requirements) are needed.
- Quote paper
- Matthias Runkel (Author), 2012, Inflation Targeting after the Crisis. The Past, Present and Future of Monetary Policy, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/285239
