Question

What is inflation targeting? How does the Fed or the ECB pursue this goal?

Answer 1

Inflation targeting refers to a policy goal of the central bank in which the central bank explicitly announces a target inflation rate and conduct monetary policies in order to achieve the target. The main underlying assumption of inflation targeting is that a stable price helps in a stable economic growth over the long-term.

The Fed or ECB conducts inflation targeting by controlling the money supply with the help of interest rate. When the inflation rate is higher than the target rate, these central bank raises the interest rate to reduce money supply so that the inflation comes down to the target level. On the other hand, when the inflation rate is lower than the target rate, these central bank lowers the interest rate to increase money supply so that the inflation goes up to the target level.