High inflation has become a problem for the Indian economy since the start of the war in Europe. The policy apparatus, which up until this point had been concentrated on reviving growth following the pandemic, has now swiftly switched its focus to inflation.

As a citizen, knowing what causes inflation is crucial. In this article, we will look at how central banks control inflation and what inflation targeting is.

How central banks control inflation

Central banks are concerned about inflation expectations because they influence the consumption habits of businesses and consumers, affecting the economy’s stability.

Generally speaking, there are two broad ways of controlling inflation in an economy ,and this includes using Monetary measures and by using fiscal measures.

Monetary measures and Fiscal measures

The Central Bank’s monetary policy is the most important and frequently employed method of controlling inflation. Central banks typically use high-interest rates to control or prevent inflation.

These measures include a bank rate policy, cash reserve ratio, and open market conditions.

During an inflationary period, the primary tool for monetary control is the bank rate policy. It is said that the central bank has adopted a dear money policy when it raises the bank rate. Because borrowing is more expensive as a result of the bank rate increase, commercial banks are less likely to borrow from the central bank. As a result, there is a decrease in money flow from commercial banks to the general public. Therefore, it is under control to the extent that inflation is brought on by bank credit.

The central bank increases the Cash Reserve Ratio (CRR) to control inflation, lowering commercial banks’ ability to lend. As a result, less money is moving from commercial banks to the general public. In the process, it reduces the price increase to the extent that public bank credits bring it on.

To keep inflation under control, the central bank sells government securities to the public through banks. This causes a portion of bank deposits to be transferred to central bank accounts, reducing commercial banks’ credit creation capacity. The central bank’s sale and purchase of government securities and bonds are referred to as open market operations.

Taxation, government spending, and public borrowings are all fiscal measures used to control inflation.

Inflation Targeting

Two things are required for inflation targeting. The first is a central bank that can conduct monetary policy independently. The second requirement is that the monetary authorities are willing and able to refrain from targeting other indicators such as wages, employment, or the exchange rate.

After meeting these two basic requirements, a country can pursue an inflation-targeting monetary policy.

Inflation targeting is a technique used by many central banks. A central bank estimates and publishes a projected inflation rate, or “target,” and then attempts to steer actual inflation toward that target using tools such as interest rate changes. Because interest rates and inflation rates tend to move in opposite directions, an inflation-targeting policy makes the likely actions a central bank will take to raise or lower interest rates more transparent. Inflation-targeting supporters believe it leads to greater economic stability.

At least in theory, inflation targeting is simple. The central bank forecasts inflation and compares it to the target inflation rate (the government believes is appropriate for the economy). The difference between the forecast and the target determines the extent to which monetary policy must be adjusted.

Because of the shocks we are experiencing – war, energy, disrupted supply chains, and re-allocation of demand – inflation is likely to remain above our target for some time. In such difficult times, central banks must rely on their inner compass – their commitment to their mandate – to maintain price stability.

The Bottom Line

Central banks oversee a country’s (or group of countries) monetary system and various other responsibilities ranging from monetary policy oversight to implementing specific goals such as currency stability, low inflation, and full employment. A low, stable, and predictable inflation rate benefits the economy. People and businesses can make long-term financial plans when they are confident in their understanding of the inflation rate leading to a more efficient economy.