The dynamics of monetary policy and inflation targeting in modern economies: A theoretical and empirical analysis

Abstract

This study investigates the evolving dynamics of monetary policy with a particular focus on inflation targeting as a key framework employed by central banks in modern economies. Drawing on theoretical foundations and empirical evidence, the paper explores how inflation targeting has shaped macroeconomic stability, influenced expectations, and interacted with other monetary tools in diverse economic environments. The theoretical section provides a detailed analysis of the New Keynesian framework, emphasizing the role of forward-looking expectations, the Taylor Rule, and the time-inconsistency problem. Empirically, the study utilizes panel data from advanced and emerging economies over the past three decades to examine the effectiveness of inflation targeting in achieving low and stable inflation, anchoring inflation expectations, and supporting output growth. The results suggest that while inflation targeting contributes to macroeconomic stability, its effectiveness is contingent on institutional credibility, fiscal discipline, and the transparency of central banks. The paper also highlights the challenges faced by monetary authorities in a low-interest-rate environment and during external shocks such as the global financial crisis and the COVID-19 pandemic. Additionally, the study assesses the interplay between monetary and fiscal policies, questioning the boundaries of central bank independence in times of crisis. Overall, the findings underscore the importance of adaptive policy frameworks and the need for coordination between monetary and fiscal institutions to sustain economic stability. The paper concludes with policy recommendations for strengthening inflation-targeting regimes in an increasingly complex global financial landscape.