Why do central banks aim for about 2% inflation instead of zero?
Voters would on average prefer prices to stay put, yet central banks around the world deliberately aim for a little inflation.
▶ Start the storyCentral banks aim for a little inflation because zero inflation leaves them, and wage-setters, with less room to manoeuvre. Most economists today favour low and steady inflation, as opposed to zero or negative. Low inflation reduces the likelihood of recessions by letting the labour market adjust more quickly, and it reduces the risk that a stops from stabilising the economy.
Take wages first. are slow to adjust downward, which can lead to prolonged disequilibrium and high unemployment. Inflation helps because it allows to fall even if nominal wages stay constant: a firm in trouble can hold pay still instead of cutting it. Now take interest rates. A central bank fights a recession by cutting rates, but if nominal rates are already at or near zero, it cannot cut further, a situation called a . A little inflation means rates normally start higher, leaving space to cut.
Step 1: Wages
Nominal pay is slow to fall, so prices rising lets real pay adjust
Step 2: Interest rates
Rates start higher, leaving room to cut them in a recession
Step 3: Measurement
Some research finds official inflation runs about 1 point above true inflation
The idea became official policy in New Zealand in 1990, when the government and the Reserve Bank agreed that the bank would pursue an inflation target range of 0 to 2 percent. Canada and the United Kingdom soon followed, making the three of them the first to adopt fully fledged inflation targeting in the early 1990s, and in most countries today the target is about 2%.
It is not a popular choice: on average voters prefer an inflation rate around 0%. And the number is debated, with one well-known economist suggesting 3% instead.
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Recap
Central banks aim slightly above zero because wages are slow to fall and interest rates cannot fall far below zero.
💡 A trick to remember it · A little upward slope keeps wages and interest rates from hitting the floor.
Surprising fact · New Zealand pioneered the policy in 1990 with a target range of 0 to 2 percent.
Sources (3)
No source, no claim. Every fact in this lesson (14 claims) cites at least one of these.