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Chapter 17: Q.7 (page 468)

How does inflation targeting help reduce the time inconsistency problem of discretionary policy.

Short Answer

Expert verified

Inflation targeting helps to cut back the time-inconsistency problem of discretionary policy because the inflation target increases the accountability of the financial organization.

Step by step solution

01

Concept Introduction 

Discretionary policy can be either a monetary or a fiscal policy that does not follow a fixed rule but rather is based on the discretion of the policymakers.Time inconsistency could be a situation within which people change preferences over time.

02

Explanation of Solution  

In Inflation targeting, the speed of inflation is fixed by the financial organization and so this rate is introduced to the general public. Inflation targeting helps to cut back the time-inconsistency problem of discretionary policy because the inflation target increases the accountability of the financial organization. Thus, it helps in reducing the time inconsistency trap of the financial organization to pursue expansionary monetary policy so as to expand output and employment within the short run.

Also, inflation targeting reduces the political pressures on the financial organisation to pursue inflationary monetary policy and thereby reduces the time inconsistency problem.

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Most popular questions from this chapter

What are the main criteria for choosing a policy instrument? Why? Explain.

If the Fed has an interest-rate target, why will an increase in the demand for reserves lead to a rise in the money supply? Use a graph of the market for reserves to explain.

“The zero lower bound on short-term interest rates is not a problem, since the central bank can just use quantitative easing to lower intermediate and longer-term interest rates instead.” Is this statement true, false, or uncertain? Explain.

7. How does inflation targeting help reduce the time inconsistency problem of discretionary policy?

What does the Taylor rule imply that policymakers should do to the fed funds rate under the following scenarios?

a. Unemployment rises due to a recession.

b. An oil price shock causes the inflation rate to rise by 1%and output to fall by 1%.

c. The economy experiences prolonged increases in productivity growth while actual output growth is unchanged.

d. Potential output declines while actual output remains unchanged.

e. The Fed revises its (implicit) inflation target downward.

f. The equilibrium real fed funds rate decreases
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