Academic journal article Contemporary Economic Policy

Inflation Targeting and the Economy: Lessons from Canada's First Decade

Academic journal article Contemporary Economic Policy

Inflation Targeting and the Economy: Lessons from Canada's First Decade

Article excerpt

CHARLES FREEDMAN [*]

Inflation targeting has become the centerpiece of the monetary policy framework in a number of industrial countries and emerging economies. The first part of this article examines the Canadian experience with inflation targeting since its introduction in early 1991 and various issues that require resolution in establishing such a framework. It also examines the way inflation targets deal with demand, price, and productivity shocks. The second part focuses on Canada's economic performance during the 1990s. Factors other than monetary policy--most notably private sector restructuring and the fiscal situation in the first half ofthe decade--played an important role in the sluggishness of the recovery from the recession of 1990-91. Trend growth in Canada during the 1990s was lower than in earlier periods and than U.S. trend growth over the same period. The article examines the role of such factors as productivity growth and participation rates in explaining the differences. I conclude that a good monetary policy is necessary but not sufficient for good economic outcomes. (JEL E52, E58, E65)

I. INTRODUCTION

This article is divided into two parts. The first part focuses on inflation targeting and how it has developed in Canada and other countries. I examine the reasons for introducing this approach to the conduct of monetary policy, its characteristics, and Canada's experience with inflation targeting in the 1990s. The second half could be titled "If inflation targeting is so good, why has the Canadian economy not done better in the 1990s?" This section examines other factors that help explain economic developments in Canada over the past decade. It can be summarized as "Good monetary policy is necessary but not sufficient for good economic outcomes," and focuses on the role of fiscal policy and private sector behavior in influencing the way the economy performs.

II. INFLATION TARGETING AS THE BASIS OF MONETARY POLICY [1]

A. The Benefits of Price Stability or Very Low Inflation

Price stability or very low inflation is not an end in itself but a means of achieving the ultimate goal of a better-functioning economy--an economy with a higher standard of living than one facing persistently rising prices.

How does price stability contribute to a better-functioning economy? Or, to put the question in a different form, why does inflation lead to less good economic outcomes?

A number of factors link inflation and poor economic performance:

1. In an economy with pervasive inflation, uncertainty about the future leads savers, investors, households, and businesses to make less effective economic decisions than in a price-stable environment, resulting in a less efficient, less productive economy. Empirically, uncertainty about inflation has been correlated with the level of inflation.

2. Another result of an inflationary environment is that resources that would be better spent on other activities are used to try and alleviate the uncertainty that results from inflation. For example, households and businesses minimize the amounts held in currency or checking accounts, while the financial industry creates new instruments to hedge against the volatility in financial markets associated with inflation. Thus, considerable time, energy, and funds are spent trying to eliminate the deleterious effects of inflation.

3. Inflation contributes to severe cycles of boom and bust. Inflation and expectations that it would worsen fueled the speculative booms in the late 1970s and late 1980s in Canada. And the painful recessions that followed were marked by distressingly high levels of unemployment, partly because of the distortions that developed in the economy during the preceding inflationary period. Indeed, every downturn in Canada since World War II has been preceded by a period of inflationary pressures. This is not to argue that the business cycle would disappear in a world of low inflation, but its amplitude would likely be appreciably lower. …

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