Controlling inflation
Warwick Business School
wbs.ac.uk
The fundamental objective for all central banks is to preserve the value of their currency. High and variable price inflation is a bad outcome for society. A lesson that we have all been personally re-learning over the past few years.
Inflation distorts relative prices and rates of return, and that interferes with economic decision making, leading the economy to run much less efficiently. It acts like a tax on holding cash – badly affecting the poorest people who tend to have fixed, low incomes whilst fixed nominal tax thresholds amplify that effect for those on regular wages. Of course, higher taxes improve the government’s financial position, but this is seldom popular!
We know that inflation can be contained by making a long-term commitment to stable prices, using interest rates as the instrument of control, albeit there are long and variable lags. Governments found that they could exploit the lags by cutting interest rates just before an election (for example), with the inflationary costs not arising until sometime later.
One of the major achievements of academic macroeconomics has been the theory and evidence which concluded that the best way to avoid such abuse was to delegate monetary policy to an independent central bank, with an explicit inflation objective. Inflation targeting or similar regimes have since been implemented in most large, developed economies and many smaller or less developed nations, with outstanding results. Until recently that is!
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