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Contemporary perspectives on the role of monetary policy emphasize three core functions: to deliver low and stable inflation; conditional on this, to moderate fluctuations in the path of domestic output by tightening or loosening monetary conditions as circumstances dictate; and to support the smooth functioning of the payments system and the financial system more generally, so as to promote the efficient market-based allocation of credit and pricing of risk.
How these broad objectives are best met is a subject of extensive and active debate, not least as central banks around the world seek to navigate the low interest rate environment that has prevailed since 2008. Nonetheless, a strong consensus has emerged from this debate in favour of systems of ‘constrained discretion’, usually framed in terms of inflation targeting and commonly found in the industrialized economies and amongst an increasing number of middle-income countries. The ‘discretion’ reflects central banks’ operational independence in the deployment of their policy instruments, while the ‘constraint’ is manifest in an explicit, verifiable, and credible target for inflation (and possibly other economic outcomes), typically set by government. A credible inflation target of this form serves to anchor inflation expectations and to tie the authorities’ hands in a way that minimizes their incentives to act in a time-inconsistent manner. With expectations anchored, space is created for the authorities to pursue output stabilization.
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