, with a continuing process of vicious inflationary circles that can harm the country for a long time. it is also a fallacy to believe that a switch from money supply to inflation targeting will enable south africa to have lower interest rates almost instantaneously. taking account once again of the intimate relationships that exist between the various components of the monetary policy model, there is but little difference between inflation targeting and money supply guidelines ( or for that matter a dce, liquidity or interest rate anchor for monetary policy ). interest rates will only decline to a lower level once inflation has been reduced on a sustainable basis to a lower level, and expectations about higher inflation in future have been eliminated with success from the minds of the majority of economic agents. 3. introducing inflation targets the introduction of inflation targeting is no easy task. apart from the question of who should be responsible for the establishment of the target, the following questions must also be answered : how should inflation be measured? although it is widely accepted that some form of a cost - of - living index or a consumer price index should be used for this purpose, there is no consensus on how exactly inflation should be measured ideally for the purpose of implementing monetary policy. one of the major deficiencies of any kind of price index for this purpose is that the statistics are based on past consumption expenditure, and do not take account of possible future purchases – a deficiency that does not apply to money supply targeting, where accumulated money balances form part of the base aggregate. at what level or range should the target be set? “ the purpose of an inflation target is to provide the central bank with a rule for making monetary policy decisions. for that purpose, a target band is not necessary : a single point target is sufficient ” ( william a. allen : inflation targeting : the british experience, a bank of england publication ). a fixed point, however, is much more difficult to hit than staying within a range. moving within a band also leaves some discretion to the central bank and can also provide more flexibility in the case of unforeseeable future price shocks. what models should be used for forecasting inflation? it must be understood that inflation targeting is about the future. any monetary policy decision implemented today, for example a decision to raise interest rates, will normally only affect actual measured inflation with a time lag of, say, twelve to eighteen months ( or even longer in some countries ). inflation targets can therefore only be set in a forward - looking model

pointed out that, apart from the fairly generally accepted ultimate goal of protecting the value of the currency, central banks can choose any one of the more important elements of the model as an intermediate target for guiding their shorter - term decisions on monetary policy. some central banks may prefer a target for total domestic bank credit extension ( dce ) ; others may prefer more direct controls over the amount of liquidity in the banking sector ; others may set a more direct objective for the level of interest rates. be that as it may, the monetary policy model as described above is a consistent model in which fairly stable relationships exist between the various components of the model. whatever element may be chosen as an anchor for monetary policy, the other components of the model cannot and should not be ignored. 2. moving from an intermediate objective to the ultimate objective of monetary policy in south africa, like in many other countries with a comparable experience of economic development, changes in the money supply in recent years lost some of their usefulness as an anchor for monetary policy, and as an intermediate objective for achieving the ultimate goal of protecting the value of the currency. this has happened, as in many other countries, mainly because of a major liberalisation of the financial markets, a huge increase in the volume of transactions in the money and capital markets, and an opening - up of the country for international participation, not only in respect of trade, but also for the inward and the outward movement of capital across international borders. in the process, huge increases in the money supply occurred that were not related directly ( or indirectly ) to total spending on real goods and services. in technical terms, the additional money supply remained in financial circulation and was reflected in a large decline in the income velocity of circulation of the money supply. more money became available for every one unit of goods and services produced in the country. and yet, these increases in the money supply did not lead to increases in the rate of inflation. on the contrary, inflation in south africa remained on a steady downward path, interrupted only by the adverse effects of the exchange rate depreciations of 1996 and 1998. reserve bank guidelines for an acceptable rate of increase in the money supply, based on the objective of a gradual reduction in the rate of inflation and providing for a desirable but realistic rate of growth in real economic activity, were overshot by a substantial margin during each of the past four years. taking account of developments in the financial markets, and the acknowledgement of a growing need for