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effect of decreasing the level of output and employment.

Whatever is the cause of inflation, monetary authorities are always responsible for fuelling and sustaining further price increases. The quantity theory of money is an useful start for understanding the reason:


If the velocity of money and output are fixed, we have a direct relationship between money supply and prices. If prices increase, the reason can only be the acquiescence of the monetary authorities. They can decide to increase money supply to accommodate a government deficit, or simply they can not to be able to calculate the right amount of money needed by the system (because of unexpected movements in the velocity of money or changes in the liquidity of some financial assets).

Q5 Inflation targeting by the monetary authorities involves three steps:

(a) deciding on a target inflation rate,

(b) forecasting inflation, and

(c) formulating and implementing a policy response should the forecast  inflation rate deviate from its target level.

Comment on each of these steps.

(Note: further details relevant to part (c) of this question are provided in chapter 13).

(a) In most countries the central bank (CB) is responsible for maintaining price stability. Either the CB or the government has to set the target inflation rate.  In the latter case the CB implements the policy needed to reach the target, which has to be consistent with a sustainable growth. It should not be too high because it can disrupt growth in the long term.  A target of 1%-2% of inflation is considered by central banks of EU countries consistent with long term growth.

(b) Once the target is set, the CB has to compute actual inflation and forecast future inflation as it would be without any monetary policy change. This task is fundamental; because of the time-lag between the implementation of a monetary policy and the effects on inflation, authorities have to be aware well in advance of the future trend of prices. They forecast inflation using:

i)   Macroeconomic and econometric models;

ii) Lead indicators: movements in indicators such as capacity utilisation in manufacturing sector, house prices, exchange rates or order books tend to precede movements in the general price index. The forecasting is concerned to the power of these indicators in predicting inflation (e.g., a 3% increase in price 'x' will lead to 0.5% increase in inflation) and the time-lag of this relationship (e.g., the increase in the general price level will be in 12 months-time).

(c) In the case that forecast inflation exceeds the targeted rate, the CB has to implement restrictive monetary policy:


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