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CFA Level I · CFA Level I Exam · Monetary Policy

A central bank states that it targets a low and stable inflation rate of 2%. The most likely reason that many central banks choose a small positive target rather than zero inflation is to:

Central banks choose a small positive inflation target mainly to reduce deflation risk and keep room to cut the policy rate. Zero inflation would leave little buffer, so shocks could push the economy into deflation while the policy rate is near its lower bound.

  1. Aeliminate the need for open market operations
  2. Breduce the risk of deflation and leave room to cut the policy rateCorrect
  3. Craise real interest rates permanently above the neutral rate

Explanation

A small positive target creates a buffer against deflation, which is damaging because it raises real debt burdens and can push the policy rate against its lower bound. Open market operations remain necessary, and the target does not raise real rates permanently.

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