Inflation Targeting

Abstract

In response to the abandonment of monetary targeting, Inflation targeting (IT) has emerged as a dominant monetary policy framework in both industrializing and industrialized countries. The framework was aimed to provide a new anchor for conducting monetary policy, and the theoretical underpinnings of this framework are based on two things: First, the IT model provides a core mechanism where the interest rate is being used as a policy instrument to achieve a low and stable inflation. Second, institutional aspect of this policy provides guidance towards an independent central bank that is argued as a way to gain a central bank’s credibility. However, the claim is not free from criticisms; some economists view this policy is implemented at the cost of low economic growth and high unemployment. This research is aimed to provide a deeper analysis on Inflation Targeting framework by addressing its two theoretical foundations: First, the standard IT model is being assessed by considering a missing variable namely labor productivity. Second, the institutional analysis is employed to explain the implementation of IT in a - typically developing - country (i.e. Indonesia), and since the IT policy follows a type of transplanted policy (from International Financial Institution to Countries), the adoption of IT policy is evaluated under the institutional transplantation perspective. As a conclusion, IT policy is not costless, the cost is not only in term of losing output but also in term of losing labor productivity, and the institutional analysis showed that the adoption of IT by a country does not increase the credibility of a central bank.