13.2 Inflation Targeting

Question 1

Central banks’ focus on inflation comes from two fundamental observations regarding macroeconomic relationships: that high inflation is costly, and that monetary policy is the ultimate cause of sustained inflation.

Answer 1

• High inflation is costly
• Monetary policy is the ultimate cause of sustained inflation.

Question 2

Examples of people or firms who suffer from high rates of inflation

Answer 2

For example, seniors whose pension incomes are not indexed to inflation suffer a reduction in their real incomes whenever inflation occurs.
Similarly, those who have made loans or purchased bonds with interest rates that are fixed in nominal terms lose because inflation erodes the real purchasing power of their financial investments.

High inflation also undermines the ability of the price system to provide accurate signals of changes in relative scarcity through changes in relative prices.
As a result, both producers and consumers may make mistakes regarding their own production and consumption decisions that they would not have made in the absence of high inflation.

Question 3

Finally, the uncertainty generated by inflation is damaging to the economy in many ways.

Answer 3

When inflation is high, it tends to be quite volatile, and this volatility makes it difficult to predict the future course of prices.

As a result, periods of high inflation are often characterized as having much unexpected inflation.

The risk of unexpected inflation makes it difficult for firms to make long-range plans, and such plans are crucial when firms undertake costly investment and R&D activities in order to expand their production facilities or to invent and innovate new products and new production processes.

Question 4

What is the result of high and uncertain inflation?

Answer 4

High and uncertain inflation reduces real incomes for many households and also hampers the ability of the price system both to allocate resources efficiently and to produce satisfactory rates of economic growth.

Question 5

What do most economits and central bankers accept as the most important determinant of a country’s long-run rate of inflation

Answer 5

Most economists and central bankers accept the idea that monetary policy is the most important determinant of a country’s long-run rate of inflation.

Question 6

When did the BoC begin inflation targeting? What is the process for maintaing this?

Answer 6

The Bank of Canada began inflation targeting in 1991 and has been doing so ever since.

Every five years, a formal agreement between the Government of Canada and the Bank of Canada is renewed, in which the Bank’s mandate and inflation target is clearly specified.

Question 7

What is the targeted rate of CPI inflation?

Answer 7

The Bank’s current objective is to keep the rate of CPI inflation close to the 2 percent target.

Question 8

Is the CPI inflation rate more or less volatile then the “core” inflation rate?

Answer 8

The CPI inflation rate is more volatile than the “core” inflation rate.

Question 9

What is the core rate of inflation?

Answer 9

The core rate of inflation in Canada is the rate of change of a special price index constructed by removing some food items, energy, and the effects of indirect taxes from the overall Consumer Price Index.

Question 10

How does the Bank of Canada keep the rate of inflation close to 2 percent?

Answer 10

In its efforts to do so the Bank closely monitors many aspects of the economy and anticipates changes in the levels of aggregate demand and aggregate supply.

In particular, the Bank monitors the output gap and the associated pressures that may be pushing inflation above or below the 2 percent target. Only then can it determine its appropriate policy actions.

Question 11

How does the Bank, in the face of a persistan recessionay gap, attempt to close the output gap?

Answer 11

Faced with a persistent recessionary gap , which eventually tends to reduce inflation below the Bank’s 2 percent target, the Bank can pursue an expansionary monetary policy. By doing so, it can attempt to close the output gap and bring real GDP back to , keeping the inflation rate close to 2 percent.

Question 12

What kind of policy does the Bank use in the face of a persistant inflationary gap?

Answer 12

Faced with a persistent inflationary gap , which tends to cause inflation to rise above the 2 percent target, the Bank can pursue a contractionary policy. By doing so, it can attempt to close the output gap and bring real GDP back toward and keep the inflation rate close to 2 percent.

Question 13

What do persistant output gaps generally create?

Answer 13

Persistent output gaps generally create pressure for the rate of inflation to change.

To keep the rate of inflation close to the 2 percent target, the Bank of Canada closely monitors the output gap in the short run and designs its policy to keep real GDP close to potential output.

Question 14

What combination is often refered to as the “divine coincidence” of inflation targeting?

Answer 14

For any central bank that is targeting inflation, its policies tend to stabilize both the rate of inflation and the path of real GDP—even though its formal mandate may not include targeting real output at all.

This combination is sometimes referred to as the “divine coincidence” of inflation targeting, and it comes from the fact that it is output gaps that create pressure for inflation to change.

Question 15

What domino effect typically occures in the face of a positive shock?

Answer 15

Question 16

What series of events typically occure after a Negative shock?

Answer 16

Question 17

What does inflation targeting tend to lead to?

Answer 17

Question 18

What are two complications in the conduct of monitary policy?

Answer 18

• Volatile Food and Energy Prices
• The Exchange Rate and Monetary Policy

Question 19

Sometimes the rate of inflation increases for reasons unrelated to a change in the output gap. What are some examples?

Answer 19

For example, many commodities whose prices are included in the Consumer Price Index (CPI) are internationally traded goods and their prices are determined in world markets.

Oil is an obvious example, as are many raw materials and fruits and vegetables. When these prices rise suddenly, perhaps because of political instability in the Middle East (in the case of oil) or because of poor crop conditions in tropical countries (in the case of fruits and vegetables), the measured rate of inflation of the Canadian CPI also rises.

Question 20

How does the Bank of Canada monitor the volitility of food and energy prices that are unrelated to the level of the output gap in Canada?

Answer 20

Because the volatility of food and energy prices is often unrelated to the level of the output gap in Canada, the Bank of Canada closely monitors the rate of “core” inflation even though its formal target of 2 percent applies to the rate of CPI inflation. Changes in core inflation are a better indicator of short-run domestic inflationary pressures than are changes in CPI inflation.

Question 21

What do changes in the exchange rate affect?

Answer 21

Changes in the exchange rate—the Canadian dollar price of one unit of foreign currency—affect the relative prices of Canada’s exports and imports.

Since Canadian firms and households do a lot of trading with the rest of the world, a change in the exchange rate can have a major impact on aggregate demand, and hence on the output gap and the rate of inflation.

Question 22

How does the BoC deal with changes in the exchange rate?

Answer 22

Because changes in the exchange rate can have several different causes, care must be taken when drawing inferences about the desired change in monetary policy resulting from changes in the exchange rate.

As we will see, there is no simple “rule of thumb” for how the Bank should react to a change in the exchange rate.

Question 23

What can BoC do in the face of increased foreign demand for Canadain exports that result from Canada’s trading partners experiencing an economic boom, in an attempt to prevent an inflationary gap.

Answer 23

Suppose that the economies of Canada’s trading partners are booming and there is an increase in foreign demand for Canadian exports.

This increase in demand for Canadian goods creates an increase in demand for the Canadian dollar in foreign-exchange markets.

The Canadian dollar appreciates. But the increase in demand for Canadian goods has added directly to Canadian aggregate demand and shifted the AD curve to the right.

If this shock persists, it will eventually add to domestic inflationary pressures. In this case, if the Bank correctly determines the cause of the appreciation it can take action to offset the positive demand shock by tightening monetary policy, which it does by raising its target for the overnight interest rate, thereby shifting the AD curve back to the left.

Question 24

What can BoC do to prevent a recessionary gap in the face of increased demand for Canadian assets as opposed to Canadian goods?

Answer 24

For the second example, suppose there is an increase in demand for Canadian assets rather than Canadian goods.

Suppose that investors, because of events happening elsewhere in the world, decide to liquidate some of their foreign assets and purchase more Canadian assets instead.

The increase in demand for Canadian assets leads to an increase in demand for the Canadian dollar in foreign-exchange markets.

The Canadian dollar appreciates. In this case, however, as the dollar appreciates, Canadian exports become more expensive to foreigners.

There will be a reduction in Canadian net exports and thus a reduction in Canadian aggregate demand. The AD curve shifts to the left. If this shock persists, it will create a recessionary gap. In this case, if the Bank correctly determines the cause of the appreciation it can take action to offset the negative demand shock by loosening monetary policy, which it does by reducing its target for the overnight interest rate, thereby shifting the AD curve to the right.

Question 25

What do changes in the exchange rate signal?

What does the BoC need to determine before they can react accordingly?

Answer 25

Changes in the exchange rate can signal the need for changes in the stance of monetary policy.

However, the Bank needs to determine the cause of the exchange-rate change before it can design a policy response appropriate for keeping real GDP close to potential and inflation close to the 2 percent target.