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Role of the central bank in controlling inflation and interest rate. Essay

The central bank plays a major role in controlling both inflation and interest rate. To control inflation many of the central banks have adopted inflation targeting regime. Inflation targeting regime was first adopted in New Zealand in 1990 but in the last 15 years it has gained wider acceptance in many developing and developed country due to it ability to maintain economic stability.

Under inflation targeting the main objective and priorities of the central bank is to attain and maintain price stability beside other objective which includes economic growth and reducing unemployment (Walsh, 2003).

The main characteristic of an inflation targeting regime that differentiates it from other monetary policy regime include:

1.      The central bank set their inflation target numerically and announces the same to the general public and is obligated to achieve that target. In case the central bank fails to achieve their target then they are accountable to the public and must give a good reason for such failure.

2.      The main aim of the central bank is to control future inflation rather than focusing on present inflation.

Therefore the central bank forecast future inflation and make them public which have led the inflation targeting regime being also known as inflation forecasting regime.

3.      Price stability as a primary goal – the central bank is committed to achieving stable and low level of inflation both in the short-run and in the long-run.

The central bank is allowed to pursue other goals subject to the condition that price remain low and stable.

4.      Transparency and accountability – with this regime communication to financial market and general public is important. Effective communication is achieved through press releases after the meeting which includes minutes of the meeting and publication of inflation reports. Where the central bank upholds transparency then accountability is enhanced. Where a comparison of inflation against the target indicate a breach of target then the central bank must give a public explanation which is in contrast to previous practice adopted by the bank (Bofinger, 2001).

The reason why many countries are shifting to inflation targeting is that it anchors inflation expectation. In addition it make it easy to understand the objective of central bank and increase accountability since the CPI figures are produced by an independent statistical office therefore cannot be manipulated by the central bank to create a favorable performance. Furthermore it influences the behavior of wage and price setting and has the effect of lowering long-run inflation expectation.

For effective implementation of inflation targeting then the central bank should be independent and there should be no fiscal dominance. Fiscal policy should be consistent with price stability goal and the government should ensure that there is no excessive deficit. Furthermore monetary financing of deficit should not be used.

In anchoring inflation target then various countries have adopted different price index e.g. point target have been adopted by UK and new Zealand, point target with a

range used by Sweden and brazil, range less than 2% points wide adopted by Israel, Poland, Chile, Australia, Czech republic and Canada, and target range of more than 2% points used by south Africa.

Inflation is described as a general increase in price level of goods and services. There are two sources of inflation

a.       cost-push

b.      demand-pull

Demand-pull inflation occurs when ever the demand for goods and services exceed available supply i.e. aggregate demand is greater than aggregate supply which creates an inflationary gap. In this case price will rise due to shortage.

Cost push inflation occurs or result from increased cost of production of goods and services making the price of goods to rise. Increase in production cost can result from increase in wages, cost of living and increase in input price which leads to a wage-price spiral. In a nut shell inflation is caused by the following factors

a.       An increase in money supply which is not accompanied by an equivalent increase in production. Using the fisher equation to explain how increase in money supply causes inflation M.Vy = P.O

Where M = money stock

            Vy = income velocity

            P = price

            O = output

Income velocity is assumed to be constant in the short-run since the method of handling money balance by banking and financial institution, the economic structure of the economy and the custom of paying habit of the community changes only gradually over time. Final output is considered to be constant since the economy would be at full employment level. This implies that the only two variables that could change were M and P. causation was assumed to run from money stock to price level. As a result a doubling of M would cause a doubling of P. 2 M.Vy = 2 P.O (Clarinda $ gali, 1999).

b.      An increase in aggregate spending which causes increase in general prices.

c.       Calamities like drought and abnormal industrial unrest that may force a reduction in supply of good and services.

d.      Hoarding – creating artificial shortages by businessmen which increases price.

e.       Speculation that prices of goods will rise in future

f.       Rise in wages.

Knowledge of the various causes of inflation helps the central bank in adopting the correct monetary policy instrument to remedy or cub inflationary pressures.

In inflation targeting regime the central bank adopt a forward looking approach through forecasting of major macro economic variables and attempting to control the rate of inflation one or two years ahead. In an inflation targeting regime the monetary policy instrument are used as intermediate targets. Where projection indicates that the inflation forecast is above the inflation target then the central bank should adopt more restrictive monetary policy. On the other hand where inflation forecast is expected to be below the inflation target then

the central bank should adopt expansionary monetary policy. This is done through the implementation of monetary policy by influencing the level of domestic credit and money supply (Michael & William, 1995).

The instruments of monetary policy that are at the disposal of the central bank include

-Open market operation – the government uses treasury bills to influence the level of money supply in the economy. Where the government want to reduce the amount of money supply in the economy then they sell Treasury bill and government bonds at a higher rate than the market interest rate this attract investors in buying government securities which reduce the amount of money supply in the economy.

This method has an indirect impact on aggregate demand since a reduction of money on the hand of household will force them to cut on their spending. This in return will cause aggregate demand to decrease easing the inflationary pressure. On the other hand when the government wants to adopt expansionary monetary policy they buy back this bond thereby increasing the amount of money in circulation in the economy.

-The bank rate – central bank influences the bank rate of commercial bank by setting the base rate. If the central bank wants to reduce the money supply in the economy then they increase the base rate. Where the bank rate increases it will increase the cost of borrowing from financial institution. This will discourage borrower and therefore reduce the money supply in the economy. For adoption of expansionary policy then the base rate is reduced making borrowing cheap.


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