Inflation Targeting

Price stability is the primary goal of inflation-targeting monetary policy strategy. Inflation is usually defined as a range of permissible values (e.g., 1%-3%) rather than as a point value (e.g., 2.4%). The definition of inflation also varies from country to country.

There are three key concepts:

Central bank independence. Central bank independence exists on two dimensions. Goal independence is the freedom that the central bank has to select the objectives of monetary policy, whether they are low inflation, the target rate of unemployment, the level of GDP, etc. Instrument independence is the freedom that the central bank has to pick appropriate policies to produce a certain outcome in the economy. Most inflation-targeting countries only lay out the goals and not the operating procedures; the central bank does have operational independence.

Credibility. Central bankers who are unable to credibly convince the public that they are serious about fighting inflation will be faced with a high inflation rate as a result.

Transparency. It is well known that credibility requires transparency. The benefits of transparency are obvious: it improves the efficiency of monetary policy, allows for a more effective management of expectations, and promotes the discussion and evaluation of monetary policy.

Exchange Rate Targeting

Many countries have viewed pegging their nominal exchange rate to a stable, low-inflation foreign currency as a means of achieving domestic price stability. In a sense, countries that target their exchange rates against an anchor currency attempt to "borrow" the foreign country's monetary policy credibility. However, this monetary policy deprives the central bank of its ability to respond to idiosyncratic domestic shocks. Such countries can become prone to speculation against their currencies.