i) The CB needs to have a clear statement of its inflation objective, it must be credible and it must be independent from the government
ii) The CB has to be aware of the economic implications of its anti-inflationary policy, especially on exchange and interest rates.
iii) The CB has to know how and when to intervene. Given the complex links between money supply and inflation, the CB usually sets intermediate targets (domestic credit, lead indicators, interest rates, exchange rates) and use policy instruments, with the appropriate time lag, to affect them: these instruments are direct measures (credit quotas, credit controls) and market-based measures (open-market operations, discount rate, reserve requirements). See also Chapter 13, pp. 341-342.
Q6 Inflation which economic agents correctly anticipate is generally regarded as less damaging economically than inflation which is unexpected. Why should this be so?
Decisions are made on the basis of expected inflation. If workers predict a change in price level, they demand a corresponding pay increase, maintaining in this way the real wage. The equilibrium is instantly restored and the economic costs of inflation are minimised.
If inflation is unexpected, workers cannot anticipate it and they lose purchasing power. Single firms can also fail to anticipate inflation, bearing higher costs than expected and risk going bankrupt. Unexpected inflation creates disruption in the efficient functioning of the markets because, by definition, it involves people trading at mistaken or 'wrong' prices in real terms.
Q1 What has been the inflation rate in your country in the past decade? What have been the determinants of this inflation?
In addressing this question, students should consult official statistics published by Central Statistics Offices and by International Organisations (i.e., IMF and OECD). Usually two series are represented, the rate of inflation at the end of the year and the average of the inflation rates during the year. What is the difference between the two?
Students should be able to see at least two peaks of inflation in the 1970s and decreasing inflation rates through the 1980s and the 1990s. Is this the case? Compare inflation rate trends with other variables linked to it (average wage in the manufacturing sector, interest rate, exchange rates, monetary variables) to infer causes and responses to inflation. Was inflation due to demand or supply-shocks? Was there any time lag between changes in these variables?
Q2 A central bank announces that inflation is 'public enemy number 1' and engages in restrictive monetary policy to reduce it from 6% to 3%.