September 10, 2002
During the past decade, numerous countries have adopted "inflation targeting" as a framework for setting monetary policy. In nearly all cases, the authorities have established a target range for the rate of price inflation, usually between 2 and 3 percent. However, the rationale for choosing these numbers is often unclear.
According to some analysts, several factors are relevant in determining an inflation target. While the target affects volatility in employment, it is itself influenced by the terms of trade, openness of trade, and the degree of wage rigidity. Accordingly, inflation targets should vary depending on a nation's characteristics.
Therefore, analysts suggest that a central bank should:
- Provide a coherent assessment of the likely implications of its announced inflation targets.
- Indicate why the preferred policy is better than feasible alternatives.
- Clarify the linkage between the announced target and the various structural features of the economy.
By doing these things, the central bank's activities become more transparent. This allows business to better understand the inflation policies. Consequently, if the structure of the economy changes and the inflation target requires change, businesses will be better able to adjust and the adjustment will have fewer negative implications.
Source: Christopher J. Erceg, "The Choice of an Inflation Target Range in a Small Open Economy," American Economic Review, Volume 92, Number 2, May 2002.
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