Macroeconomics

Abstract

Post the gold standard crisis after the World War I, the earlier economists proposed monetary policies targeting the inflation rate over the exchange rate. Irving Fisher, one of the first proponents of price targeting, came up with a “compensated dollar” system so that the amount of gold content in paper money would be dictated by the variation in the price of goods in terms of gold. This would have the effect of keeping the price level in terms of paper money fixed. The international economy was subjected to several instances of sudden inflation and deflation right after World War I. This prompted John Maynard Keynes to recommend a policy of exchange rate flexibility where in the government appreciates the currency when the international economy inflates and depreciates it in the face of deflationary pressure in the international market. This would make the internal prices immune to international fluctuations, helping maintain price stability. But this early interest in price targeting gave way to exchange rate targeting as economists rallied behind the latter. Exchange rate targeting means that the central bank is using country’s currency’s exchange rate with respect to another low inflation country as the nominal anchor to stabilize price levels. But this meant that the country’s monetary framework was essentially the same as the country to which it had pegged its currency. This also limited the effectiveness of central bank’s response when faced with a shock like unexpected change in terms of trade or variations in the real interest rate. Consequently, most of the countries following exchange rate targeting gradually adopted floating exchange rates making them search for a new nominal anchor. This was when inflation targeting made a comeback, capturing the imagination of the period’s prominent economists. New Zealand became the first country to formally adopt inflation targeting in 1990. New Zealand was followed by Canada and several other countries of the world. This framework became so widely used that economists starting associating all economies with an inflation target, even the countries that did not have them – at least now formally. .