Answer to Question #106885 in Macroeconomics for Usman Tariq

Question

Why was Peru inflation targeting system successful?

Answer 1

Peru inflation targeting system was successuful because of two instruments which were used by central bank:

-reference interest rate(it was a main policy instrument).

-accumulation of sufficient foreign-exchange resrves.

When there were unfaurable external shocks and inflation went beyond the celling of the target range, the central bank redused the interest rate and sold foreign currency. When there were favorable external shocks the central bank raised the interest rate and bought foreign currency.

The expected inflation is given and, if the central bank increases, for example, the referencen interest rate, this is expected to push up nominal and real lending interest rates

and/or to reduce the volume of bank credit. Moreover, if the central bank increases, fore example the reserve requirement ratio, this is also expected to push up nominal and real lending interest rates and/or to reduce bank credit. Aggregate demand depends inversely on real lending interest rates and directly on the quantity of bank loans, while production and employment depends on aggregated demand. And finally, the price level(inflation) depends directly on the gap between effective and potential output, with the latter taken as given.

So, actions listed above have allowed the central bank to preserve macroeconomic stability in favorable or unfavourable external context.