Inflation targeting and its trade-offs: which statement best describes this framework?

• A. A central bank fixes the exchange rate and uses inflation targeting.
• B. Inflation targeting is achieved by setting a fixed inflation cap.
• C. A central bank targets a specified inflation rate; trade-offs include balancing inflation stability with output/stability and credibility.
• D. Inflation targeting is a tool to maximize long-run growth irrespective of inflation

Answer: (C)

Inflation targeting works by the central bank committing to achieving a specified inflation rate over time, using policy instruments and clear communication to guide expectations. The framework emphasizes price stability but also recognizes that policy choices to keep inflation on target can affect real activity in the short run, so there’s a trade-off between inflation stability, output stability, and the credibility of the central bank. It’s not about fixing the exchange rate, not about enforcing a fixed inflation cap, and not about maximizing long-run growth regardless of inflation.