On Inflation Targeting

The rate of Inflation is of great concern to the Central Bank of a country as well as to its Government.

This concern of the authorities is what makes ‘inflation targeting’ important. But should it be the only concern’

What is ‘Inflation targeting”

Inflation targeting is a framework for operating monetary policy. The first authority to formulate it was the Reserve Bank of New Zealand in the early 1990s. It is undertaken by the monetary authorities and it tries to keep the price stable without adversely affecting output and employment. [Khatkhate 2006]

On Phillips curve

The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Although several people had made similar observations before him, A. W. H. Phillips published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. [Hoover]

Inflation targeting has gained a lot of importance, mainly owing to the downward slope of the Phillips curve.


NAIRU or Non-accelerating inflation rate of unemployment was introduced by Milton Friedman and Edmund Phelps during the 1970s.

NAIRU is a steady state unemployment rate above which inflation would fall and below which inflation would rise.

The natural rate of unemployment is a key concept in modern macroeconomics. Its use originated with Milton Friedman’s 1968 Presidential Address to the American Economic Association in which he argued that there is no long-run trade-off between inflation and unemployment: As the economy adjusts to any average rate of inflation, unemployment returns to its “natural” rate. Higher inflation brings no benefit in terms of lower average unemployment, nor does lower inflation involve any cost in terms of higher average unemployment. A second important unemployment rate is the “Non-Accelerating Inflation Rate of Unemployment,” or NAIRU. This is the unemployment rate consistent with maintaining stable inflation. According to the standard macroeconomic theory enshrined in most undergraduate textbooks, inflation will tend to rise if the unemployment rate falls below the natural rate. Conversely, when the unemployment rate rises above the natural rate, inflation tends to fall. Thus, the natural rate and the NAIRU are often viewed as two names for the same thing, providing an important benchmark for gauging the state of the business cycle, the outlook for future inflation, and the appropriate stance of monetary policy. [FRBSF Economic Letter 1998]

A digression

I am digressing from ‘inflation targeting’ and am going to talk about a welcome proposal by the Indian Government.

In a bid to obtain a `true picture’ of the effect of price changes on the economy, the Union Finance Ministry has proposed the inclusion of services in the Wholesale Price Index (WPI) which is used to measure point-to-point inflation. In India, the services sector accounted for 54 per cent of the GDP during the previous fiscal year. [The Hindu 2007]

In an earlier post of mine, I had argued for a restructuring of the WPI.


Giving too much significance to the ‘Inflation rate’ without adequate and corresponding developments in food supply, public distribution systems, etc will not help combat the problems of unemployment. Thus the fiscal and monetary authorities must ensure that such areas are targeted during a ‘rise in inflation’.

Increasing interest rates and importing food grains so as to bring down inflation rates will not succeed as the ‘inflation’ is basically caused by distributional inefficiencies.


1) Deena Khatkhate, Inflation Targeting, Dec 9 2006, EPW.

2) Kevin D. Hoover, The Concise Encyclopedia of Economics.

””’ 3) Federal Reserve Bank of San Francisco, The Natural Rate, NAIRU, and Monetary Policy, 1998.

Further Reading

1) The Phillips curve by Bradford DeLong.

2) The NAIRU by Bradford DeLong.

3) History and Theory of the NAIRU: A Critical Review by Espinosa and Russell.

””’ 4) Why inflation still matters, Frontline, Jayati Ghosh, 2006.

Inflation: Is WPI fallible’

The textbooks define Inflation as a situation where too much money chases too few goods i.e. the purchasing power of money has decreased. Actually, only an increase in the general price level for a considerable period of time is called as Inflation in Economics. The 2 major causes are Demand pull factors and Cost push factors. The present reason for inflation to increase is owing to the increase in the global prices of oil which comes under cost push factors.

What is the WPI’
Wholesale price index or WPI is the measure for inflation in India. The government comes out with WPI inflation figures every Friday. The WPI presently consists of 435 items and it is dominated by manufactured goods which make up 63.75% of the index.

Current scenario
In 2005-06 inflation has been experiencing a free fall in spite of escalating crude prices.
Currently the inflation rate is about 4.6% which is clearly undervalued as when compared to the increases in the prices of goods and services. The prices of pulses, transportation has all increased considerably but the WPI does not seem affected much.

Components of WPI
In the computation of WPI, the 3 major variables are Primary articles (weight 22.0), Fuel, power, light and lubricants (weight 14.2) and manufactured products (weight 63.7). Manufactured products have always enjoyed more weight in the calculation of WPI.

Cause of worry
One reason is that, the prices of commodities are increasing due to the increased costs, mainly in transportation. But there has been no corresponding increase in wages. The people who are poor will find it difficult to live as they were living before the price hike.
The second is that, the retailers take advantage of this situation by hoarding up commodities, further fuelling inflation. And the third reason is that, services do not form a part of the WPI though its share in the GDP is 52%. Surprisingly, the WPI inflation rates are just hovering between 4.5% and 5%, which tells us not to worry. History has told us to take inflation rates seriously only if the rate crosses 8%.

Government reaction
The government has decided to reduce customs duties on imports of wheat and sugar in order to increase the domestic supply. The government wants to reduce inflationary pressures by mopping up the excess demand in the economy.

A paradox
Like mentioned in the beginning of this article, the current cause of inflation is an increase in the global oil prices which is a cost push factor. How can the government be so blind in not seeing this’ Instead it has gone to the extent of giving duty free imports to reduce excess demand in the economy, when there has been no excess demand!

The immediate step to take will be the reconstruction of the WPI so that it indicates the genuine level of inflation. Like our outdated poverty line, which tells that only about 26% of the Indian population is poor, the current WPI is also outdated.