Business Economics · Recent macroeconomic history

The Great Moderation and Inflation Targeting Explained

Updated 11 October 2026 · Fact-checked

The Great Moderation was the period from the mid-1980s to 2007 when inflation was low and output growth was stable in many advanced economies. Inflation targeting, where an independent central bank sets interest rates to hit a announced inflation target, is widely credited as one cause, alongside good luck and structural change.

Understand The Great Moderation and Inflation Targeting

The Great Moderation is the name given to the period from about the mid-1980s to 2007 when the volatility of output growth and inflation fell sharply in the US and many other advanced economies. Recessions were milder and less frequent. Inflation, which had been high and unstable in the 1970s, stayed low.

Three explanations are usually given. The first is better policy: central banks learned to control inflation and expectations. The second is good luck: fewer large shocks such as oil price spikes. The third is structural change: better inventory management, a bigger services sector, deeper financial markets and globalisation that kept goods prices low. Economists still disagree about the weight of each. Do not present one cause as proven.

The policy story rests on two ideas. Central bank independence means the central bank chooses interest rates without day-to-day political direction. This reduces the temptation for governments to boost output before an election at the cost of higher inflation. Inflation targeting means the government or central bank announces a numerical inflation target, and the bank sets its policy rate to meet it, usually over a one to two year horizon.

How it works: if forecast inflation is above target, the bank raises the policy rate. Borrowing costs rise, spending and demand slow, and inflation falls back. If forecast inflation is below target, it cuts rates. Because the target is public, people expect inflation to stay near it. Those anchored expectations make wage and price setting more stable and make the target easier to hit. The approach was adopted by New Zealand in 1990 and later by the UK, Canada and many others. India adopted a flexible inflation targeting framework in 2016.

The period ended with the 2007-08 financial crisis. Critics argue that focusing on consumer price inflation let asset price bubbles and financial risks build up. Stable inflation did not guarantee financial stability. This criticism is a common exam point.

Key rules to remember

Inflation rate: Inflation rate (%) = (P₁ − P₀) ÷ P₀ × 100; P₀ is the price index in the base period and P₁ in the later period. Use this to compare actual inflation with the target.
Real interest rate (approximate): Real rate ≈ nominal rate − expected inflation; Central banks aim at the real rate. The exact form is (1 + nominal) ÷ (1 + inflation) − 1.
Taylor rule (one common form): i = r* + π + 0.5(π − π*) + 0.5(y gap); i is the policy rate, r* the neutral real rate, π inflation, π* the target and y gap the output gap in %. It is a guide to how rates respond, not a rule central banks follow exactly. Coefficients vary by version.

How to solve The Great Moderation and Inflation Targeting questions

Use this method for any question on the Great Moderation, central bank independence or inflation targeting.

1Read the command word. 'Explain' needs mechanism, 'discuss' needs both sides, 'evaluate' needs a judgement.
2Define the key terms in one line each: Great Moderation, inflation target, independence.
3Give the period and the facts: low and stable inflation and growth, mid-1980s to 2007.
4Explain the mechanism step by step: forecast inflation, rate change, borrowing cost, demand, inflation, expectations.
5Give causes or arguments on both sides: policy, luck, structure; or advantages and disadvantages of independence.
6Add the limits: asset bubbles, zero lower bound, supply shocks, and the 2007-08 crisis.
7Finish with a short reasoned conclusion that uses the evidence and does not overclaim.

Quickest way: Cause, mechanism, limit

When to use it: Use for short written answers and to eliminate wrong MCQ options quickly.

Name the cause: policy, luck or structure.
Write the chain: rate rises, demand falls, inflation falls, expectations anchor.
State one advantage and one limit.
For MCQs, reject options that say the target controls output directly or that the Great Moderation was caused by one factor alone.

Common mistakes in The Great Moderation and Inflation Targeting

Saying the Great Moderation was caused only by inflation targeting.
Textbooks stress the policy story, so students treat it as the full answer.
Fix: Always list policy, good luck and structural change, and say economists disagree on the weights.
Dating the Great Moderation to the 1970s or after 2008.
Students mix it up with stagflation or the post-crisis era.
Fix: Remember: mid-1980s to 2007, between the 1970s stagflation and the crisis.
Confusing central bank independence with a central bank setting its own target.
The two ideas are taught together.
Fix: Independence usually means freedom over instruments. The target is often set by the government or agreed with it.
Giving only advantages of independence.
Students remember the credibility argument and stop.
Fix: Add disadvantages: limited democratic accountability, possible conflict with fiscal policy and a narrow focus on inflation.
Claiming low inflation means financial stability.
Students overlook how the crisis followed the Moderation.
Fix: State that stable consumer prices coexisted with housing and credit bubbles, so the framework was criticised.

Worked examples

Example 1

A country's price index rises from 125 to 131.25 over a year. Its inflation target is 4%. (a) Calculate inflation. (b) Compare with the target and state the likely central bank response.

Show the solution

Inflation = (131.25 − 125) ÷ 125 × 100.
131.25 − 125 = 6.25.
6.25 ÷ 125 = 0.05, so inflation is 5%.
Target is 4%, so inflation is 1 percentage point above target.
If forecast inflation stays above target, the bank would raise the policy rate to reduce demand.

Answer: Inflation is 5%, which is 1 percentage point above the 4% target. The bank would be likely to raise the policy rate.

Example 2

Discuss the advantages and disadvantages of central bank independence.

Show the solution

Define: independence means the bank sets interest rates without day-to-day political direction.
Advantage 1: it removes the incentive for politically timed stimulus, so inflation is lower and more stable.
Advantage 2: it builds credibility, so expectations stay anchored and the cost of disinflation falls.
Disadvantage 1: officials are not elected, so accountability to voters is weaker.
Disadvantage 2: monetary policy may clash with fiscal policy, and a narrow inflation focus may miss financial risks, as before 2007-08.
Conclude: independence helped during the Great Moderation, but it works best with clear accountability and attention to financial stability.

Answer: Independence improves credibility and lowers inflation bias, but weakens democratic accountability and can conflict with fiscal policy. On balance it is beneficial if paired with transparency and a financial stability role.

Exam tips

Give dates and the sequence: 1970s stagflation, then the Great Moderation, then the 2007-08 crisis.
In 'discuss' questions, give both sides and a conclusion. Single-sided answers lose marks.
Draw the transmission chain in words each time: rate, borrowing, demand, inflation, expectations.
Link to Indian context briefly if relevant: flexible inflation targeting from 2016. Do not quote exact numbers unless you are sure.

Practice questions from Recent macroeconomic history

The Great Moderation and Inflation Targeting: frequently asked questions

What was the Great Moderation in economics?

It was the period from the mid-1980s to 2007 when inflation and output growth were low and stable in many advanced economies. Explanations include better monetary policy, good luck and structural change.

How does inflation targeting work?

The central bank announces a numerical inflation target. It adjusts its policy interest rate so that forecast inflation returns to the target over the medium term. A credible target also anchors public expectations.

What are the disadvantages of central bank independence?

Officials are unelected, so accountability is weaker. Policy may clash with government fiscal policy. A narrow focus on inflation can also lead the bank to overlook asset bubbles and financial risk.

Did the Great Moderation end with the financial crisis?

It is usually dated as ending around 2007-08 with the global financial crisis. The crisis showed that stable inflation did not prevent a buildup of financial risk.