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Study Notes

How can a central bank combat high inflation?

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 23 Jan 2023

This study note asks the question: How can a central bank combat high inflation?

A central bank can use several tools to combat high inflation, including:

  • Raising interest rates: By raising interest rates, the central bank makes borrowing more expensive, which can decrease spending and slow down economic growth. This in turn can decrease inflationary pressures.
  • Tightening monetary policy: The central bank can decrease the money supply by selling government bonds or raising reserve requirements for banks. This can also decrease spending and slow down economic growth, which can decrease inflationary pressures.
  • Intervening in the currency market: The central bank might try to achieve a currency appreciation which would then reduce the prices of imported goods and services and perhaps reduce cost-push inflation.

Examples of countries where central banks have successfully combated high inflation include:

  • Brazil: In the 1990s, Brazil had hyperinflation that reached over 1,000%. The Central Bank of Brazil successfully brought inflation under control by implementing tight monetary and fiscal policies, including raising interest rates and implementing a currency peg to the US dollar.
  • Turkey: In the early 2000s, Turkey had high inflation that reached over 30%. The Central Bank of Turkey successfully brought inflation under control by implementing tight monetary policy, including raising interest rates and decreasing the money supply.
  • Chile: In the 1970s and 1980s, Chile had high inflation that reached over 300%. The Central Bank of Chile successfully brought inflation under control by implementing tight monetary policy, including raising interest rates and implementing a monetary rule that tied the money supply to the rate of economic growth.

It's important to note that these actions can have negative effects on the economy such as higher unemployment, lower economic growth and less investment, so central banks have to balance the inflation target with the other economic goals.

What is the role of a country having an inflation target?

An inflation target is a specific rate of inflation that a central bank or government aims to achieve over a certain period of time. The role of a country having an inflation target is to provide a framework for the central bank or government to make monetary and fiscal policy decisions and to provide predictability for businesses and households.

The main benefit of an inflation target is that it helps to anchor inflation expectations, which can reduce volatility in inflation and in the economy as a whole. When businesses and households have a clear understanding of what the central bank or government is aiming to achieve with regard to inflation, they are better able to plan for the future and make decisions that will not be destabilized by unexpected changes in inflation.

An inflation target can also help to guide the central bank or government in making monetary and fiscal policy decisions. For example, if the central bank or government is aiming to achieve an inflation target of 2%, it may make decisions to raise interest rates or decrease government spending if inflation is expected to rise above 2%.

Examples of countries that have adopted inflation targeting are United Kingdom, Canada, New Zealand, Australia, and most of the European Central Banks.

It's important to note that having an inflation target does not guarantee that the central bank or government will be successful in achieving it, as other factors such as changes in global economic conditions or natural disasters can affect the inflation rate.

What is the inflation target in the UK?

The inflation target in the United Kingdom is set by the Bank of England (BoE). The target is for the rate of inflation as measured by the Consumer Prices Index (CPI) to be 2% per year.

This target was first established in 1992, as part of the government's monetary policy framework, which gives the BoE operational independence to set monetary policy in order to achieve the inflation target. The BoE uses a range of monetary policy tools, such as setting interest rates and controlling the money supply, to try to achieve the inflation target.

The target of 2% is considered to be a "medium-term" target, meaning that the BoE aims to keep inflation close to 2% over the longer-term, rather than trying to achieve 2% every month or every quarter. This is because inflation can be affected by short-term fluctuations in the economy, such as changes in oil prices, and it is difficult to control these fluctuations in the short term.

It's important to note that the inflation target is not a "hard" target, meaning that the BoE doesn't have to achieve it exactly, but it should be as close as possible. The bank of England's monetary policy committee will take into account other economic factors when they decide on the monetary policy actions.

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