A project report on inflation targeting: should central banks adopt it? Environment and Economic PolicyINFLATION TARGETINGDefinitionThe inflation targeting framework refers to a set of economic policies adopted by the central bank in which it announces an expected or "target" inflation rate and strives to achieve that figure using measures such as variations interest rates and other monetary instruments. Elements of Inflation Targeting[1] · Announcement of an explicit quantitative inflation target or range for a certain period of time. · The central bank must show clearly and unambiguously that its most important objective is to provide a stable price environment. · The central bank should have powerful models to forecast inflation. · The central bank must have a forward-looking operating procedure where the definition of policy instruments depends on the assessment of inflationary pressures and where inflation forecasts are used as the main intermediate target. Prerequisites for Inflation Targeting[1] · The central bank should be able to conduct monetary policy with a certain degree of independence. · Absence of another target variable such as wages, employment level, or nominal exchange rate · Existence of a stable and predictable relationship between monetary policy instruments and the inflation rate. Problems with the implementation of Inflation Targeting1. Time Inconsistency Situations Time inconsistency situations may arise because the central bank would seek short-term reoptimization and lose sight of long-term objectives. The bank may start with a particular policy and then continue to modify it to meet some short-term needs. Such behavior would not have the desired effect. This effect can be explained using an inflation targeting model. [2]2p = pT-a(xu)p = inflationpT = target inflation percentagex= output gap (Y-Yn ) / Ynu= fluctuationsa=l/aka= constant, k= measure of the cost of inflation fluctuationl= measure of the cost of output fluctuation Let us consider the case where the fluctuations, u=0. For a given value of "x", the value ofp would change if the value of a changes. If the central bank continuously changes the importance it attaches to its objective of achieving a target inflation rate and maintaining a zero output gap, the value of a would vary and the achieved inflation rate would continually fluctuate causing inflation forecast errors2 . Exchange Rate Volatility A study of exchange rate variability in countries that adjusted target inflation shows that although variability decreased in the first 3 years of adopting the policy, the coefficient of variation was enormous when considering the overall period. (Ref Table 1). Such huge currency depreciations would increase the dollar denomination