Lesson 4 of 8 · All lessons in this module
- What central banks do and what they aim for
- The three tools: open market operations, policy rate, reserve requirements
- How a rate change reaches growth, inflation and the currencyVideo lesson
- Effective central banks and inflation targeting
- Exchange rate targeting and policy in developing economies
- Expansionary or contractionary? The neutral rate and the source of shocks
- Limits of monetary policy: weak transmission, deflation and quantitative easingVideo lesson
- How monetary and fiscal policy interact
Lesson 4 of 8 · 14 min
Effective central banks and inflation targeting
An effective central bank is independent, credible and transparent; inflation targeting builds on those three qualities by promising a clear, forward-looking inflation goal, usually about 2%.
In short
- Three qualities make a central bank effective: independence, credibility and transparency.
- Operational independence: the bank sets interest rates. Target independence: it also chooses the inflation measure, level and horizon.
- Credibility matters because a believed target becomes self-fulfilling: expectations feed into wages and prices.
- Transparency (inflation reports, clear explanations) builds credibility and makes expectations easier to anchor.
- Typical target: about 2% CPI inflation with a band of about ±1 point, aimed at inflation about two years ahead. Not 0% (deflation risk) and not much higher (volatile, uncertain inflation).
- Two prominent central banks without a formal New-Zealand-style target: the Bank of Japan (long fight against deflation) and the US Federal Reserve (dual mandate; about 2% core PCE seen as stable prices).
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