PERI Working Paper Series, Number 62

Abstract: Many countries in the developing world have adopted an approach to monetary policy that focuses on maintaining a low level of inflation, to the exclusion of other important objectives such as employment generation, increasing investment or reducing poverty, despite the widespread evidence that moderate levels of inflation have few or no costs. Some have even adopted formal “inflation targeting”, an approach which commits the central bank to hitting a fairly rigid inflation target, often as low as 2%. However, this focus has led to slower economic growth and lower employment growth, without succeeding in lowering inflation at a smaller economic cost than traditional methods of inflation fighting. Clearly, it is time to find an alternative to inflation targeting.

This paper presents the real targeting approach to monetary policy, which I argue is superior alternative to the costly and ineffective inflation targeting approach. Under this real targeting approach, central banks are given a country appropriate target such as employment growth, unemployment, real GDP or investment, usually subject to an inflation constraint. Given these two targets-the real target and the constraint-the central bank will find multiple tools to reach these targets, designing new tools and rediscovering old tools such as asset based reserve requirements and other credit allocation techniques. The real targeting approach might also be complemented by other policies, such as capital management techniques to deal with possible capital flight. The real targeting approach has the potential to make central bank policy more transparent, more accountable, and more socially useful than most currently existing central bank structures.