inflation targeting framework: indonesia in comparison

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Final Monetary Economics Paper

Inflation Targeting Framework: Indonesia in

Comparison

Fahrana Amita

Mihra Dildari

Prasya Aninditya

Rudy Banse

Fakultas Ekonomi Universitas Indonesia

Depok, June 2013


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Table of Contents

CHAPTER I INTRODUCTION ............................................................................ .................................. 3

CHAPTER II LITERATURE REVIEW.................................................... ............................................. 4

Monetary Policy ........................................................ ................................................................. ............ 4

Inflation ............................................................. ................................................................. ....................... 4

Inflation Targeting Framework (ITF) .......................................................... .................................. 5

CHAPTER III ANALYSIS ................................................................ ........................................................ 6

Indonesia ........................................................................................... ....................................................... 6

Monetary Policy and Inflation ......................................................... ............................................. 6

Inflation Targeting Framework (ITF) in Indonesia ............................................................. 7

Evaluation of ITF in Indonesia ......................................................................................... ............ 8

Canada .................................................................................................................................................... 10

Bank of Canada ...................................................... ................................................................. ......... 10

Monetary Policy Instruments .......................................................... .......................................... 11

Monetary Policy Framework ............................................................................................ ......... 12

European Union .............................................................................................................. .................... 16

The Institutional Framework and the ECBs Goal ............................................................. 16

Monetary Policy Instruments .......................................................... .......................................... 18

The Effect of ECBs Monetary Policy ....................................................................................... 19

CHAPTER IV CONCLUSION .......................................................... .................................................... 23

REFERENCES ....................................................... ................................................................. .................... 25


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CHAPTER I INTRODUCTION

Inflation is a topic which is often covered in the media and must therefore have

an important meaning. But why inflation is such an important topic, not only to

economists but also to society as a whole? What can be done to control the level of

inflation? And if something can be done, how effective are the policies used to control

inflation? This paper is intended to gain some basic knowledge to be able to answer

these and other questions involving inflation and the monetary policy used to control

inflation. The main topic of this paper is the inflation targeting framework, the

monetary policy of the National Central Bank to maintain price stability. As we will

see, many countries already set an inflation target and use their monetary policy to

achieve this goal. In this paper the monetary policy of three Central Banks will be

discussed and compared to get an idea of how effective they are in maintaining price

stability.

The first section of the paper will give a brief theoretical background of the most

important terms which will be discussed. In the next chapter there will be a review of

literature to explain the instruments of monetary policy and the effects of them. With

this knowledge the reader can continue to the third section in which there will be acase analysis of three Central Banks that implement an inflation target.

This paper will end with a conclusion on the analysed cases and a comparison of the

effectiveness of the monetary policy from the three discussed Central Banks.


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CHAPTER II LITERATURE REVIEW

Monetary Policy

Monetary Policy is considered as a process which the monetary authorities of a

country control one or more aspects in monetary area to obtain objectives towards

growth and stability of the economy. These monetary authorities say the

government, the central bank or other monetary authorities are using the size and

growth rate of money supply which in turn affects the interest rates. On the contrary,

fiscal policy focuses more on taxations and governmental spending to influence the

economy. So, monetary policy is the management of money and interest rates.

In most countries, monetary policies are maintained through actions in

changing the amount of money banks need to keep or increasing the interest rates.

There are strong relations between money supply and interest rates, as to control

inflation the central bank will usually raise the interest rates which triggers people to

invest their money in banks so the money supply in the economy is reduced. Further

in this paper, we will know how the monetary policies are applied.

Inflation

Originally, inflation is referred to increases in the amount of money in

circulation. But nowadays, the term inflation is used to refer a continual increase in

level of prices of goods and services in an economy over a period of time causing

purchasing power to fall. Thus, an increase in the price of a good alone cannot be

considered as inflation, unless this increase will lead to other increases in the price of

other goods. Inflation will affect individuals, businesses, and the government simply

everyone in the economy. Ever since, inflation is a problem that is visible to all theeconomies over the world and is an important problem to be solved.

There are two types of inflation:

1. Demand-pull inflationThis type of inflation occurs when there is an increase in aggregate demand,

categorized in households, businesses, governments and foreign buyers.

Excessive demand can happen when these sectors compete to purchase limited


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amounts of goods and services. This will lead to an increase in general level of

prices that causes inflation.

2. Cost-push inflationIt basically means that the increase of price is triggered by increases in costs of

any factors of production (labour, capital, land and entrepreneurship) when

companies are already running at full production capacity. With higher

production cost and productivity maximized, companies cannot maintain profit

margins by producing the same amount of goods and services. As a result, the

increased costs are passed on to consumers, causing a rise in general price level

(inflation).Consumer Price Index (CPI) is used to indicate the inflation rate over time

showing movements of goods and services consumed by public. It is calculated by

comparing the average price increase for goods that are consumed daily from base

year to current year. A significant increase in CPI indicates that the country suffers

inflation, and on the other hand, a significant decrease in CPI indicates deflation.

Inflation Targeting Framework (ITF)

To support the monetary authorities control inflation in an economy, there is

one new approach through monetary policy to control inflation that is called Inflation

Targeting. What is Inflation Targeting? ITF is an economic policy which the central

bank estimates a projected inflation rate and attempts to maintain inflation towards

the target through the use of interest rates and other monetary tools. It is

characterized by setting an inflation target, announcing to public, and pursue its

target as the primary goal of monetary policy.

ITF implementation differs in each country due to the law implied in each of

them. We will then discuss about ITF in Indonesia and later on we will compare it

with implementation of ITF in other countries.


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CHAPTER III ANALYSIS

Indonesia

Monetary Policy and Inflation

Based on UU No. 3/2004 clause 7 concerning Bank Indonesia, the goal of Bank

Indonesia is to achieve and maintain the stability of rupiah. For this objective, Bank

Indonesia uses nominal anchors, which requires credibility from the commitment

towards these anchors. If it is credible which means that public can rely on it has

important benefits towards the economy. To achieve this goal, in 2005, Bank

Indonesia decided to adopt Inflation Targeting Framework (ITF) in which inflation isthe primary monetary objective followed by floating exchange rate system. Bank

Indonesia has the authority to define monetary target regarding inflation rate target,

perform monetary control, determine minimum reserve, and regulate funding to

support monetary objective achievement.

Bank Indonesia defines inflation as a continual increase in level of prices of

goods and services. Not only it uses CPI to measure inflation rate, Bank Indonesia also

use GDP Deflator as a measurement by dividing GDP based on nominal prices by GDP

based on constant prices. For the determinants of inflation, Bank Indonesia

categorizes them into 3 groups; cost-push inflation, demand-pull inflation and

expectations. Expectation or the estimation of inflation rate would affect public

behaviour; whether they prefer to be adaptive towards it, or forward-looking.


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Chart above shows the inflation rate movements from year of 2008 until current

year. In 2008, U.S suffers a great financial crisis which affects many countries in the

world including Indonesia. At that time, the level price of oil increases, which leads

Indonesia to face quite high inflation rate compared to the year after.

Why is it so important for Indonesia to maintain inflation rate? Stability of

inflation rate is required for the sustainable economic growth that will bring benefits

through improvements in wealth, based on the opinion that unstable inflation will

have negative impact on the welfare of society. Under this consideration, inflation

becomes the main focus of monetary policy.

Inflation Targeting Framework (ITF) in Indonesia

Since July 2005, Bank Indonesia improves their monetary policy with Inflation

Targeting Framework (ITF) principles. Bank Indonesia defines ITF as a monetary

policy marked by announcements to the public in the inflation target to be achieved

over the next several periods; in explicit terms, low and stable inflation is described

as the overriding objective of monetary policy. The implementation of ITF in

Indonesia follows the basics that ITF is used as a framework, and not as a rule. Bank

Indonesia executes ITF based on these elements:

1. Bank Indonesia rate is used as an operational monetary target replacing themoney in circulation due to the fall in the relationship between inflation rateand money supply.


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2. The monetary policy is strengthened with forward looking strategy that ismonetary policy needs to act well before inflationary pressures appear in the

economy.

3. Implementation of ITF must be supported by good and effectivecommunications along with transparency to public, so that public have a

complete understanding about this policy.

4. Improved coordination with government, because there are some aspects thatcannot be controlled by Bank Indonesia.

The ITF is applied in Indonesia as a framework, not as a rule. So, basically Bank

Indonesia will set Inflation as their primary monetary objective by applying some of

ITFs nature; all policies regarding to inflation will be considered by Bank Indonesia

for future conditions (forward looking strategy), all events concerning inflation rate

will be announced to the public so that public will have the idea of inflation growth

and what to do in the economy, and last Bank Indonesia will improve their

coordination with government regarding inflation determinants that cannot be

controlled by Bank Indonesia itself.

Evaluation of ITF in Indonesia

To evaluate the effectiveness of ITF, Bank Indonesia uses Aggregate Rational

Inflation-Targeting Model for Bank Indonesia (ARIMBI) with imperfect credibility to

evaluate ITF over period. ARIMBI is technically a small scale macroeconomic that

adopts QPM Model enhanced with monetary policy credibility. This model is shown

by the diagram below:


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Figure 1 - Aggregate Rational Inflation-Targeting Model for Bank Indonesia (ARIMBI) model structureE

Based on this model, Bank Indonesia will evaluate whether inflation projection

is on track with the adopted target of each period. If it is no longer on track, based on

this ARIMBI model, Bank Indonesia will adopt a tight monetary policy by controlling

interest rates. As explained before, monetary policy should have credibility so the

public will rely on what they were doing; therefore Bank Indonesia issues regular

explanations to public on the assessment of the inflation conditions.

Year Inflation Target Actual Inflation

2002 9 10 % 10,03 %

2003 9 1 % 5,06 %

2004 5,5 1 % 6,40 %

2005 6 1 % 17,11 %

2006 8 1 % 6,60 %

2007 6 1 % 6,59 %

2008 5 1 % 11,06 %

Table 1 - Comparison for Inflation Rate (source: www.bi.go.id)

In the table above, we can evaluate the effectiveness of ITF. At the time of ITFimplementation, Indonesia suffers high rate of inflation. This s caused by the turnover


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from crawling band policy to ITF. But after ITF implementation, Bank Indonesia has

succeeded to suppress inflation rate around their target, except for 2008 which

inflation was caused by the world financial crisis due to the fall of Wall Street in the

US.

Figure 2 - 10 years Inflation Rate in Indonesia (source: www.bi.go.id)

Up until today, Bank Indonesia has been able to keep inflation rate below 10%

which means that ITF is effective to maintain price stability. As we know that the

inflation in Indonesia is mainly caused by government policies in volatile goods and

administered prices, Bank Indonesia still announces these decisions to the public.

Thus, public will have the idea of what really is going on in the economy so that public

can also take action towards these conditions. Although the inflation rate seem lower

than before ITF was implemented, inflation in Indonesia is still high compared to its

neighbour countries such as Malaysia and Thailand.

Canada

Bank of Canada

Bank of Canada was established in 1913. Its main functions are (1) conducts

monetary policy, (2) issues bank notes, (3) oversees financial system, and (4)

provides fund-management services for the Government of Canada.

1. Monetary Policy


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The Bank contributes to solid economic performance and rising living standards

for Canadians by keeping inflation low, stable and predictable. Since 1991, the

Banks monetary policy actions toward this goal have been guided by a clearly

defined inflation target.

2. Issues bank notesThe Bank designs, produces and distributes Canadas bank notes and replaces

worn notes. It deters counterfeiting through leading-edge bank note design,

public education and collaboration with law-enforcement agencies

3. Financial SystemThe Bank promotes a stable and efficient financial system in Canada and

internationally. To this end, the Bank oversees Canadas key payment, clearing

and settlement systems; acts as lender of last resort; assesses risks to financial

stability; and contributes to the development of financial system policies.

4. Fund ManagementThe Bank provides effective and efficient funds-management services for the

Government of Canada, as well as on its own behalf and for other clients. For the

government, the Bank provides treasury-management services and administers

and advises on the public debt and foreign exchange reserves. In addition, the

Bank provides banking services to critical payment, clearing and settlement

systems.

Monetary Policy Instruments

There are several instruments used by Bank of Canada for monetary policy:

1. Required reserve ratioRR ratio in Canada is zero. Bank of Canada no longer requires charteredbanks to hold a minimum level of reserves.

2. Open market is the purchase or sale of government of Canada securities by theBank of Canada in the open market.

How an Open Market Operation Works:

When the Bank of Canada conducts an open market operation by buying agovernment security, it increases banks reserves.

Banks loan the excess reserves.

By making loans, they create money.


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The reverse occurs when the Bank of Canada sells a government security.

3. The overnight-rate targetThe overnight rate is the interest rate at which major financial institutions

borrow and lend one-day (or "overnight") funds among themselves; the Bank

sets a target level for that rate. This target for the overnight rate is often

referred to as the Bank's key interest rate or key policy rate. Changes in the

target for the overnight rate influence other interest rates, such as those for

consumer loans and mortgages. They can also affect the exchange rate of the

Canadian dollar.

Monetary Policy Framework

Bank of Canada has two frameworks for monetary policy, Flexible Exchange rate

and Inflation-control Target.

Flexible Exchange Rate

Canada has operated under a flexible exchange rate for the last 50 years.

Flexible exchange rate is when the exchange rate of the Canadian dollar against any

currency is determined by the demand for and supply of Canadian dollars in the

foreign exchange market. Shock absorber is referred as rise and fall of a floatingCanadian Dollar along with sharp movements in commodity prices. This helps

Canadas economy to adjust with less overall loss in output and employment than if

the exchange rate did not move.


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Figure 3 - General Equilibrium Conditions with Flexible Exchange Rate (source: Bank of Canada)

When there is shock in foreign economies, that shock will be absorbed by

movement in the exchange rates, thus reducing its impact on domestic economy. As

can be seen in the above diagram, any shock that shift Aggregate Demand (AD) to the

left, the real rate of interest declines and exchange rate depreciates. Exchange rate

depreciation and the decline in real interest rate will increase net export and

investment, and hence output will remain stable.

If, on the contrary, the Bank of Canada follows a fixed exchange rate regime, any

external shock will be transmitted to domestic economy. When AD shift to left, and

the Bank of Canada committed to maintain the exchange rate, output will drop to Y2.

(See the diagram below)


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Figure 4 - General Equilibrium Conditions with Fixed Exchange Rate (source: Bank of Canada)

Inflation Target

Canada adopted Inflation Targeting Framework since 1991. The objective was

to reduce inflation from 4 per cent to 2 per cent by the end of 1995. Even before 1995,

Canada had reached the target.

Figure 5 - Inflation Rate in Canada based on CPI (source: Bank of Canada)


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As shown in the figure above, inflation rate before ITF was volatile and never

reached under 4 percent. ITF helps Canada to stabilize inflation rate with inflation-

control range 1-3 per cent, so the averaged is 2 per cent. A key component of Canada's

success with inflation targeting has been a strong and increasing commitment to

transparency and the communication of monetary policy strategy to the public

The Bank carries out monetary policy by influencing short-term interest rates. It

does this by raising and lowering the target for the overnight rate. When interest

rates go down, people and businesses are encouraged to borrow and spend more,

boosting the economy. But if the economy grows too fast, it can lead to rising inflation.

The Bank will then raise interest rates to slow down borrowing and spending, thus

putting a brake on inflation. The Bank of Canada sets the Target for the Overnight

Rate at a level that will keep inflation low, stable, and predictable over the medium

term. Low and stable inflation provides a favourable climate for sustainable growth in

output, employment, and incomes.

ITF objective is to control inflation. In the short-run, theres a trade-off between

Inflation Targeting and output growth. When inflation controlled, the measure has an

effect in economic growth. For example, if inflation rate above the inflation control

range, bank central may set a contractive policy (e.g., by increasing interest rate). The

policy will reduce inflation, but on the other hand, that will also cause a decline in

output.

But in Canada, ITF increase the stability in output growth. The key to Canadas

success is its ability to curb expected inflation. When the central bank announces

lower inflation target, people revise their expectations accordingly, making the short-

run aggregate supply shift to the right. The result was lower inflation and stable

output growth around its potential levels.


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Figure 6 - Real GDP Growth of Canada

During the 1980s, the annual rate of output growth fluctuated between -3 per

cent and +6 per cent, but on a few occasions was outside this range. Since 1992,

output growth has always been in the narrower range of +1 per cent to +6 per cent

(www.bankofcanada.ca). But Ball and Sheridan (2005) (in Mishkin (2005)) have

stated that there is no evidence that inflation targeting improves performance as

measured by the behaviour of inflation, output, or interest rates.Mishkin later stated

that Ball and Sheridans statement is unwarranted. As stated earlier, the key to

Canadas success was credibility of the central bank policies.

European Union

This part of the paper will discuss the monetary policy of the European Central Bank

(ECB). The first part will give a brief explanation of the institutions of the European

Monetary Union and the goal of the Euro-systems monetary policy. In the second

section there will be an explanation why the ECB uses price stability as its main goal.The third part will describe the instruments the ECB uses in its monetary policy and

this will be followed by a discussion of the effects of the ECBs monetary policy.

The Institutional Framework and the ECBs Goal

The European Central Bank (ECB) and European System of Central Banks (ESCB)

were start up in January 1999. These institutions now control the monetary policy for

the countries that are member of the European Monetary Union. However, the ESCB

consists of the ECB and the National Central Banks (NCB) of the 27 EU member states,


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whether they use the euro or not. The Eurosystem on the other hand consists of the

ECB and the NCBs of only the 17 countries that adopted the euro as their currency.

As long as there are EU member states that dontuse the euro as their currency, a

distinction between the Eurosystem and the ESCB is needed. (Mishkin, 2013)

The legal framework for a shared monetary policy is stated in the Treaty on

European Union (TEU), the Treaty on the Functioning of the European Union (TFEU),

and the Statute of the European System of Central Banks and of the European Central

Bank. The Treaties and the Statute of the ESCB, established the ECB, the Eurosystem

and the European System of Central Banks (ESCB).

In the TFEU the primary objective of maintaining price stability is set for the

Eurosystem. Article 127 (1) of the Treaty states:

"Without prejudice to the objective of price stability", the Eurosystem shall also

"support the general economic policies in the Union with a view to contributing to the

achievement of the objectives of the Union. These include inter alia "full employment"

and "balanced economic growth". (European Central Bank)

From this article we can conclude that the Eurosystem has a hierarchy of

objectives and that price stability is seen as the most important factor to achieve the

other goals of economic growth and high employment. This type of mandate is called

as a hierarchical mandate because the goal of price stability is put first, and if this

objective is achieved other goals can be pursued.

With the new Lisbon Treaty the clear mandate of the ECB, to maintain price

stability, was not only confirmed but also reinforced. This is because price stability is

not longer the primary goal of the ECB only, but also to the European Union as a

whole.

The ECB has set a clear numerical benchmark because it aims to maintain the

inflation below, but close to, 2%. But what is definition of inflation according to the

ECB? Inflation refers to a general increase in consumer prices and is measured by an

index which has been harmonised across all EU member states: the Harmonised

Index of Consumer Prices (HICP). (European Central Bank, 2011)


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The ECBs inflation target makes it clear that inflation rates above 2% are not

consistent with price stability and also that very low inflation rates, especially

deflation, are not consistent with price stability either.

Monetary Policy Instruments

In order to achieve its primary objective, the Eurosystem uses a number of

monetary policy instruments. This set forms the operational framework for the single

monetary policy of the EU. The operational framework of the Eurosystem consists of

the following instruments:

1. Open market operations. The Eurosystem has two types of regular open marketoperations:

Main refinancing operations (MROs): these are operations to provideliquidity in Euros for one week. The goal of MROs is to control the short-

term interest rates, to manage the availability of liquidity and to give a

signal on the monetary policy of the Eurosystem.

Longer-term refinancing operations (LTROs): these are operations toprovide liquidity in Euros for three months well as three-month euro

liquidity-providing operations (longer-term refinancing operations or

LTROs). The goal of the LTROs is to provide additional longer-term

refinancing for the financial sector.

2. Standing facilities. The Eurosystem offers credit institutions two standingfacilities:

Marginal lending facility: this facility offers the possibility to obtainovernight liquidity from the central bank, but the credit institution has to

present enough assets.

Deposit facility: this facility offers the possibility to make overnightdeposits at the central bank.

3. Minimum reserve requirements for credit institutionsThe ECB requires credit institutions which at based in the euro area to hold

deposits on accounts with their national central bank. These are called

"minimum" or "required" reserves. (European Central Bank, 2011)


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These instruments are the direct instruments of the ECB because the ECB has

full control over them. But with these direct instruments the ECB can try to steer their

indirect instruments which consist of the money supply and the interest rates which

in turn can influence the inflation rates.

The Effect of ECBs Monetary Policy

The way in which monetary policy is influencing the economy is complex but it

can be explained as followed. Because the central bank is the only issuer of banknotes

and bank reserves, it has the monopoly in the supply of the monetary base. The

monetary base consists of:

1. Currency in circulation: coins and banknotes.2. The reserves held by counterparties with the Eurosystem.3. Funds of credit institutions deposited at Euro-systems deposit facility.

As a result of this monopoly, the central bank is able to influence the money

market and with that also the short-term interest rates. (Mishkin, 2013)

In the short run, a change in money market interest rates by the central bank

activates the so called monetary policy transmission mechanism. This processinvolves a number of mechanisms and actions, by certain parties in the economy,

which in the end will influence economic variables such as output and prices. The

process is complex and there is still not a single view on all the aspects and effects

which are involved. Therefore it is difficult to predict what the effect of monetary

policy exactly will be on the economy and price levels. The following graph and

explanation give an illustration of the most important mechanisms and effects of

monetary policy decisions. (European Central Bank, 2011)


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Figure 7 - The monetary policy transmission mechanism (source: The European Central Bank, 2011)

1.

Change in official interest rates: The ECB provides funds to the banking systemand in return it receives interest on these funds. Because it has the monopoly in

the supply of money, the central bank can fully determine this interest rate. The

effect of the supply of money on the interest rates was already explained earlier

in Chapter 2.

2. Change in bank and money-market interest rates: The change in the officialinterest rates affects money-market interest rates direct and indirectly the

lending and deposit rates. These are the rates that are set by banks to theircustomers.

3. Effects on expectations: Expectations of future official interest-rate changesaffect the medium and long-term interest rates. And because the monetary

policy influences the future inflation, there is also an effect on the expected

future price developments. This can cause economics agents to increase or

decrease their prices in fear of inflation or deflation.

4. Effects on asset prices: The change in interest rates changes the costs offinancing an investments or purchases. This can lead to changes in asset prices


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as the demand for them may increase or decrease. As a result of that the level of

consumption and investments can also change because of the change in wealth.

For example, as equity prices rise, share-owning households are becoming

wealthier and may choose to increase their consumption. Conversely, when

equity prices fall, households may reduce consumption.

5. It can also lead to a change in the exchange rates. As a result of that the inflationcan be affected directly because imports are becoming more expensive or

cheaper.

6. Effects on saving and investment decisions: Changes in interest rates affectsaving and investment decisions of households and firms. For example, higher

interest rates make it less attractive to take out loans for financing consumption

or investment.

7. Affects the supply of credit: For example, higher interest rates increase the riskthat borrowers are unable to pay back their loans. Banks may cut on the amount

of funds they lend to households and firms. This can reduce the consumption

and investment.

8. Changes in aggregate demand and prices: Changes in consumption andinvestment will change the level of domestic demand for goods and services

relative to domestic supply. When demand exceeds supply, upward price

pressure is likely to occur.

Economists agree on the fact that in the long run, after all adjustments of the

monetary transmission mechanism, a change in the quantity of money will only result

in a change of the general level of prices. So it will not create permanent changes in

variables of the real economy such as output and unemployment. This general

principle is called "the long-run neutrality of money and it at the base ofall standard

macroeconomic thinking. Variables in the real economy, as real income and the

employment level, are in the long term determined by real factors. Examples of the

real factors that drive the real economy are technology, population growth or the

preferences of economic agents. (Mishkin, 2013)

In the long run the ECB can only stimulate the growth of the economy by

maintaining a stable level of price because this is the only variable they can control. It


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cant increase the economic growth by expanding the money supply or keeping low

short-term interest rates.

So we can conclude that inflation is a monetary phenomenon in the long run.

Other factors, such as variations in aggregate demand, technological changes or

commodity price shocks can influence the price level on in the short term. Over time

these effects can be offset by a change in monetary policy.

From the following graph it can be seen that the ECB has been relatively

successful in achieving price stability. Since the start of the Eurosystem, the inflation

rate has fluctuated around 2 percent with the exemption of the 2008 until 2010

resulting from the financial crisis.

Figure 8 - Inflation rate in the Euro area (source: European Central Bank)


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CHAPTER IV CONCLUSION

From the previous case analysis we saw that monetary policy is used by the

different central banks in order to control the level of inflation. In their monetary

policy the central banks use different instruments but they all tend to achieve their

inflation target.

Bank Indonesia has implemented the interest target framework to try to

stabilize the value of the rupiah. The BI rate is used as an operational monetary target

and Bank Indonesia uses their control over the supply of money, money in circulation,

to influence the inflation rates. The effects of this approach can be seen from the

theory discussed earlier. But in the case of Bank Indonesia, the inflation rates have

shown stability around the target level of inflation, ever since the recent financial

crisis.

To achieve the inflation target, the Bank of Canada decided to implement the

flexible exchange rate system and to use their overnight rates to influence the short-

term interest rates. The result of their policy is positive because after the

implementation of their target, the inflation rate has been fluctuating within the

target range of one to three percent.

The European Central has three different instruments in their monetary policy

which they use to control the money supply and thereby the interest rates. The

change in interest rates will eventually, through a complex mechanism; result in a

change of the price level. In the long run the ECB, and any other central bank, can only

influence the price level using monetary policy. The ECB has been relatively

successful in maintaining a stable level of inflation since the start of the EMU and with

that the setting of inflation target. They managed to keep the inflation rate around

their target and on average below but close to 2%. Although the recent financial crisis

showed great fluctuations in the level of inflation and the ECB had difficulties to

control the level of inflation.

From the analysis of the three central banks we can conclude that they all set

different inflation targets and are using different instruments to achieve their target.But what the central banks have in common is that they try to influence the interest


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rates, with their monetary policy, and with that they try to control the level of

inflation. As was discussed in this paper, monetary policy can only control the level of

inflation and cant influence any other economic variable in the long run. So central

banks are able to control the level of inflation with their monetary policy and this is

shown by the inflation rate data over the past years. All the discussed central banks

were able to control the level of inflation around their target, except for the years of

the financial crisis.

So in conclusion we can say that central banks use different instruments in their

monetary policy to achieve their inflation rate target. And with their monetary policy,

the central banks discussed in this paper show to be able to control the level of

inflation around their target.


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REFERENCES

The International Monetary Fund. Inflation Targeting: Holding the Line. Consulted at

25 May 2013 through

Http://www.frbsf.org/education/activities/drecon/2007/0703.html

Federal Reserve Bank of San Fransisco. Inflation Targeting. Consulted at 27 May 2013

through http://www.frbsf.org/education/activities/drecon/2007/0703.html

Bank of Canada. Monetary Policy. Consulted at 24 May through www.bankofcanada.ca

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