Should banks practice inflation-targeting? Give reasons to support your answer

Inflation-targeting refers to the practice in which the central bank is legally required to focus only on keeping inflation low.

Economists have not reached a consensus on whether a central bank should be required to focus only on inflation or should have greater discretion. For those who subscribe to the inflation-targeting philosophy, the fear is that politicians who are worried about slow economic growth and unemployment will constantly pressure the central bank to conduct a loose monetary policy—even if the economy is already producing at potential GDP. In some countries, the central bank may lack the political power to resist such pressures, with a result of higher inflation but no long-term reduction in unemployment. The U.S. Federal Reserve has a tradition of independence, but central banks in other countries may be under greater political pressure. Or in another scenario, central bankers may be tempted to tinker continually with the interest rate, pushing it up and down from month to month in a way that creates uncertainty and risk in the economy. Besides, inflation-targeting also has its risks. A central bank that focuses only on inflation will not use expansionary monetary policy to fight a recession. In the early 2000s, for example, unemployment rates rose in many European countries, but the European Central Bank focused only on keeping inflation rates low and not on whether it might have been wise to run a more expansionary monetary policy.

For all of these reasons—long and variable lags, excess reserves, and controversy over economic goals—monetary policy in the real world is often difficult. But the basic message remains that central banks can affect aggregate demand through the conduct of monetary policy and in that way influence macroeconomic outcomes.