INFLATION TARGETING AND OPTIMAL LEVEL OF IT
Sukumar Nandi
Indian Instutute of Management Lucknow
India
In a macroeconomics class, one student
asked, “What is inflation?” Before
answering the question, I took a little pause
and then gave the text book answer. The
student was not satisfied and that was
along the line of my expectation and that is
why I took a pause. Even today it is difficult
to convince a student of a different
discipline about the nature of inflation.
The reasons are not difficult to understand.
Measuring inflation is a difficult task,
though to make survey of prices of
commodities over time is conceptually easy.
But when that information is used to make
some index, problems emerge from two
sources. First, price movements may be a
transitory phenomenon, or noise. Sources of
such noise may be seasonal pattern,
resource shocks, exchange rate changes, or
asymmetric price adjustments. But noise
should not affect policy makers’ actions.
The second problem comes out of biases
that are consequences of weighting pattern,
sampling technique or quality adjustment
used for price calculations. The problems of
biases is much more important compared to
the existence of noises in the sense that
central bank’s particular target of inflation
and the monetary policy attuned to that
target may be influenced by that bias
(Shapiro and Wilcox, 1998).
The monetarist theory of inflation explains
that more than optimum amount of supply
of money will induce demand expansion
and that additional demand will be
liquidated by an overall increase in prices of
commodities. This demand-pull inflation
has the problem that all commodities may
not get price hike and also the price increase
may not be at the same rate.
In 1960s economists discovered that
inflation may be possible even without
increase in money supply and they came
with the idea of cost-push inflation. But
how cost escalation starts leading to price
rise, remains a naughty question.
If we collect data for a long list of
commodities for the last twenty years, we
will see that real prices of many
commodities have gone down (electronics
and many consumer goods), while prices of
essential goods have increased many fold.
This asymmetry in the price behavior
makes the problem complex and it creates
distortions in the economy by making
distribution of factors non-optimal.
In a symposium sponsored by the
Committee for Economic Development on
the theme "What is the most important
economic problem to be faced by the United
States in the next twenty years?" in 1958
Professor Samuelson commented that the
threat being asked is nothing but inflation.
In an explanatory vein, he further observed:
"The history of the twentieth century …… has
been pretty much a history of rising prices...
inflation is itself a problem. But the legitimate
and hysterical fears of inflation are - quite aside
from the evil of inflation itself - likely, in their
own right, to be problems. In short, I fear
inflation. And I fear the fear of inflation.
Avoiding inflation is not an absolute
imperative, but rather is one of a number of
conflicting goals that we must pursue and that
we may often have to compromise. Even if the
military outlook were serene - and it is not -
1
 Inflation Targeting and Optimal Level of it- Sukumar Nandi

modern democracies must expect in the future Inflation is what is explained in the above
to be much of the time at, or near, the point paragraphs. Considering its importance,
where inflation is a concern. Our greatest economists have suggested two approaches
economic problem will be to face that concern to address this issue:
realistically, to weigh inflation's quantitative (i) Economic policies targeting zero
evil against the evils of actions taken against it, inflation, and
to develop methods of adjusting to the residue of (ii) Economic policies targeting a
inflation which attainment of the 'golden mean' moderate rate of inflation.
might involve. The challenge is great but the
prognosis is cheerful." Coming to (ii) first some economists argue
that a moderate rate of inflation, say 3 per
[From Nobel Lectures, Economics 1969-1980, cent is good for the economy, as that helps
Editor Assar Lindbeck, World Scientific
in the efficient choice of factor combination
Publishing Co., Singapore, 1992 ]
in face of downward rigidity of factor
prices ( Svensson, 1997 ).
What Professor Samuelson said in the
perspective of American economy is also
Thus, a literature on inflation targeting has
true for other regions of the world
developed and theoretical framework has
including India. If we compare the
been analyzed to compare inflation
experience of Indian price levels with the
targeting with targeting of real exchange
same in the 1970s, we find that price
rate.
movements had become much more
complex in the 1970s. And the following
At present, twenty-two countries in the
decades has been a mad race among money
world are practicing inflation targeting and
supply, prices and money incomes that had
with different objectives (Table 1). But while
left a section of society marginalized and
inflation targeting is common, there are
much worse off. This is the distribution
differences among these countries
effect of inflation and for this, inflation is a
regarding the emphasis and accordingly
macro phenomenon-much hated, but also
monetary and fiscal policies are formulated.
debated in the literature.

TABLE 1
Countries having objectives as inflation targeting: 2007

Australia (H) Brazil (P) Canada ( M) Chile (C)

Colombia (H) Czech Republic (H) Finland (C) Hungary (H)
Iceland (H) Israel ( M) S. Korea( H) Mexico (P)
New Zealand (P) Norway (H) Peru (P) Philippines (H)
Poland (H) South Africa (P) Spain (H) Sweden ( P)
Thailand (H) United Kingdom (H)
Source: Truman ( 2007 ), Page 29.
Notes:: Meaning of the alphabets within the parentheses are the following:

C  Currency stability as principal objective

H  Hierarchy with price stability first
M  Multiple objectives and no hierarchy
P  Price stability as sole objective

2
 Metamorphosis Vol. 7 No.1, 2008

There are at least two problems regarding inflation targeting. First, price stability is one
primary objective of the central bank of the country. With that objective in view, central
bank keeps a target inflation rate in view that may or may not come in public domain.
To attain this objective, it depends on two important parameters of macroeconomics –
the expected growth rate of gross domestic product ( RGDP) and the income elasticity of
cash balance ( IECB). Since the Quantity Theory of Money (QTM) explains that inflation
is largely determined by the differential of two growth rates – the RGDP and the growth
rate of money supply (RMS). If the central bank has the idea of IECB from historical
data, money supply is controlled in such a way that it takes care of the target inflation
rate given the estimate of the differential (RMS – RGDP).

But since inflation is a continuous process, it enters into the expectation of the
individuals while they adjust their demand for cash balance as the trade off is the
interest foregone for maintaining sufficient liquidity. Thus, the estimate of IECB may
change over time and that may create problem for the central bank.

Let us now consider (i) , or the target of zero inflation rate. Since inflation has many
negative influences on the economy and keeping a moderate inflation target is
sometimes difficult, some economists support the view that zero inflation should be the
target (Poole, 1999).

But target of zero inflation creates problem for effective functioning of monetary policies
when the economy is afflicted with business cycles. Because of the Fisher Equation
(Fisher, 1930) money interest is the sum of real interest rate and expected inflation rate 1.
If the economy is in the downswing, the central bank comes under pressure to reduce
interest rate and any significant reduction of interest rate in face of zero inflation rate
targeting may drastically reduce the real interest rate and it may even become negative.

The monetary policy of the central bank is reflected in the pattern of growth of the
money stock and not the movement of the interest rate. The primary duty of the central
bank is to provide optimum liquidity in the economy and in that pursuit it controls the
money stock given the projected figure of the gross domestic product. In this perspective
the question of optimum rate of inflation is important and skeptics raise the question
whether it is functionally possible for a central bank to follow a uniform rate of inflation
as a target. Rather is it not natural that in the process an inflationary expectation
becomes built-in into the system and then inflation in real form becomes evident? This
has been the experience in many countries.

1
Irving Fisher used to interpret his famous equation as the nominal interest should adjust to the changes in the inflation
rate with some lags and the equation explain how interest rate would behave in a world with people having ‘foresight’ ,
which in modern interpretation may be termed as ‘rational expectation’.
REFERENCES

Fisher, Irving, The Theory of Interest, London: Macmillan, 1930.

Poole, William, “Is Inflation too Low?”, Federal Reserve Bank of St. Louis Review, July – August ,
1999, pp 3 – 10 .

Shapiro, Matthew D. and David W. Wilcox, “Bias in the Consumer Price Index”, NBER
Macroeconomics Annual, edited by B. Barnanke and J. Rotenburg (eds), MIT Press, 1998.

Svensson, Lars E. O., “Optimal Inflation Targets, ‘Conservative’ Central Bank, and Linear
Inflation Contracts”, American Economic Review,(March), 1997, pp 98 – 114 .

Truman, Edwin, Inflation Targeting in World Economy, Institute of International Economics, 2007