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IAI Actuarial Core Principles · Business Economics · Recent macroeconomic history

Under a flexible inflation targeting regime, actual inflation rises above the target because of a temporary global oil price shock, while output is falling below potential. Which response is most consistent with flexible targeting?

Flexible inflation targeting allows the central bank to look through a temporary supply shock and bring inflation back to target over a longer horizon, while also weighing the output shortfall. Strictly forcing inflation down at once would be a stricter approach and would worsen the output fall.

  1. ARaise interest rates sharply regardless of output so inflation returns to target immediately
  2. BPeg the exchange rate to the dollar to import lower inflation
  3. CAdopt a money supply target and abandon the inflation target
  4. DLook through the temporary supply shock to some extent and return inflation to target over a longer horizon, giving weight to outputCorrect
  5. Cut interest rates to zero to push inflation higher still

Explanation

Flexible targeting lets the central bank accept a longer path back to target after supply shocks, giving some weight to output stability. Immediate sharp tightening is strict targeting and would deepen the output gap.

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