In modern times, the cornerstone of monetary policy is inflation targeting, an approach in which the central bank sets an inflation target and uses all its tools to achieve it. It was pioneered by the New Zealand central bank and has been adopted by many other economies. Its success depends on central bank independence, credibility, and transparency.
In addition to central bank independence, credibility and transparency, the level of the inflation target and the time horizon in which a central bank must meet it is also important. Most central banks target (headline) inflation of 2% with a range of 1-3% two years ahead. It is because inflation close to 0 runs the risk of deflation which would render monetary policy ineffective while high inflation, such as 10%, may increase inflation expectations and associated risk premium related to inflation uncertainty.
Exceptions to inflation targeting
Even though inflation targeting is widespread, the two most prominent economies, Japan and the US, do not explicitly follow inflation target. Japan has been suffering from deflation which renders inflation targeting meaningless, but some economists believe that an explicit target by Bank of Japan may take the economy out of deflation, but consistent failure by BoJ to trigger inflation has reduced the credibility of any such measure.
Inflation targeting in developing countries
There are many impediments to effective monetary policy in developing countries, including (a) lack of liquidity in government bond markets and interbank market, (b) rapidly changing economy, (c) rapid financial innovation, (d) poor credibility resulting from poor track record in controlling inflation, and (e) unwilling of governments to grant genuine independence to central banks.
Exchange rate targeting
In exchange rate targeting, a central bank pegs its currency to a foreign currency, such as US Dollar. If a central bank sets an exchange rate consistent with the relative values of both currencies, and there is little difference in inflation rates between the countries, the exchange rate would stay close to the target. However, if domestic inflation increases but the foreign inflation does not, the domestic currency would start to fall relative to the foreign currency and the central bank must purchase its currency to support its value. This reduces domestic money supply and increases interest rates which acts to reduce domestic inflation. The opposite occurs when domestic inflation is lower than foreign inflation.
Exchange rate targeting may cause volatility in the money supply in an economy and its success depends on the credibility of the central bank. Historically, many instances have occurred in which central banks have been forced to abandon exchange rate targeting due to speculative attacks. Alternatives to exchange-rate targeting include managed exchange rate policy and dollarization.