Everything You Need to Know About Flexible Inflation Targeting in India

Jul 05, 2018 | 4 months ago | Read Time: 3 minutes | By iKnowledge Team

What is flexible inflation targeting?

Flexible inflation targeting is a monetary policy strategy used by Central Bank to maintain the price level within a certain range. This strategy indicates the importance of price stability as the prime factor of monetary policy. Inflation targeting is known to bring more stability, predictability, and transparency in deciding monetary policy. This is because of the argument that rising prices create uncertainties and adversely affect savings and investments.

Why Does India Need Inflation Targeting?

Consider this, if central banks could ensure price stability, this leverages the household and companies to plan confidently while negotiating wages based on expecting low and stable inflation.

Conversely to the strict inflation targeting, where the central bank concentrates on achieving inflation which is close to target inflation. Inflexible inflation targeting, the central bank is primarily concerned about factors like exchange rates, interest rates, output condition, and employment.

The inflation targeting rate range from 1.5%-2.5% in general. A higher inflation targeting has in most cases lead to a surmountable growth in the long run.

Flexible Inflation Targeting in India

Drawbacks-

Generally, inflation targeting has certain drawbacks as follows-

  • The government loses its credibility if it is unable to restrict the inflation in the predefined target range. This leads to a loss of faith in the government by the public which makes it imperative to achieve the decided target levels.
  • How is an inflation target achieved? This target is achieved by keeping an eye on the interest rates, that is, when interest rates are raised it keeps the inflation targeting in a limit. However, if you follow a policy inflation targeting method it can lead to a high-interest rate thus hurting investment.
  • Another drawback of flexible inflation targeting is the central bank, like RBI, can lose control over the exchange rate to some extent.
  • Inflation targeting is a comparatively easier concept to understand by a layman. For this, the central bank is required to be more transparent with information. Reserve Bank of India has been following interest rate targeting for quite some time now. That said, this is the first time it has announced an inflation targeting policy. RBI has a strong control over monetary aggregates at the present because of which it is unlikely to face any major problems due to flexible inflation targeting.

However, the RBI is now required to work under more constrained environment. For example, due to excessive capital inflow in the country, RBI will probably be unable to cut rates and instead might increase them in 2018 to keep in the inflation at 4% (+) limit.

Changes and Understandings from Inflation Targeting

Over the past few years the changes in the Indian inflation has thought numerous important lessons as follows:

First, as inflation expectations stabilize, RBI is now required to into aspects like price impact of moving to the Goods and Services Tax (GST) or a hike was seen in the house rent allowance (HRA) paid to the government employees. Though the food and fuel price shocks are more complicated, the monetary policy need not immediately respond to these temporary price shocks by increasing or slashing the respective rates. A strong response to these volatile prices can result ultimately in expanding the output gap.

The second pointer to be considered is that policymakers should be given more preference to core inflation not only in policy discussion but also in forecasting models.

Third, attention is to be given to the two equal halves of the economy, both the food sector with flexible prices and non-food sector with rigid prices. Managing the two with a common monetary policy can be a challenging and a tricky task but should be managed nevertheless.

After understanding the inflation targeting in India, the aspects of stabilization and growing credibility of monetary policy should take a more thought-through approach and not frantically respond to every unexpected shift in price levels.

Advt. no.: IA/Jun 2018/4123


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