1

CH 18: Conduct of Monetary Policy

Goals and Targets

2

Goals of Monetary Policy

Goals 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict

3

High Employment

High employment is a worthy goal for two reasons:

1. The alternative situation, high unemployment, causes much human misery, with people suffering financial distress, loss of personal self-respect, and in crime.

2. When u is high, the economy has not only idle workers but also idle resources, resulting in a lower GDP.

4

Economic Growth

The goal of steady economic growth is closely related to the goal of low u, because businesses are more likely to invest in physical capital to productivity and growth when u is low. If u is high and factories are idle, it does not pay for firms to invest in additional physical capital.

5

Hence, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest.

6

Price Stability

• In recent years, policymakers have become increasingly aware of the social and economic costs of inflation and more concerned with a stable P as a goal of economic policy.

• In fact, P stability is viewed as the most important goal for monetary policy because:

7

1. inflation creates uncertainty that may hamper growth

2. inflation makes it hard to plan for the future

3. inflation may damage a country’s social fabric (by creating conflicts between different groups)

4. extreme inflation, known as hyperinflation, leads to slower growth, as for example in Argentina, Brazil, and Russia in the recent past.

8

Interest-Rate Stability

Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty and make it harder (for both firms and households) to plan for the future.

9

Stability of Financial Markets

Financial crises can interfere with the ability of financial markets to channel funds from surplus to shortage units, thereby leading to a sharp contraction in economic activity.

The promotion of a more stable financial system in which financial crises are avoided is thus an important goal for a central bank.

10

The stability of financial markets is also promoted by i stability because fluctuations in i create uncertainty for financial firms, affecting both their profits as well as their net worth.

11

Stability in Foreign Exchange Markets

The effect of exports and imports

Also, preventing large changes in Ex makes it easier for firms and people involved in international trade to plan ahead.

12

Stabilizing extreme movements in E in Ex markets is thus viewed as a worthy goal of monetary policy.

In fact, in countries that are even more dependent on foreign trade, stability in FX markets takes on even greater importance.

13

Tools

1. Open market operations.

2. Discount policy and loans.

3. Reserve requirements.

14

Use of (Operating and Intermediate) Targets Suppose that the Bank wants to achieve

a 5% rate of growth for nominal GDP and is targeting an aggregate (say M1).

If the Bank feels that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M1 (its intermediate target), which will in turn be achieved by a 3% MB growth rate (its operating target), it will use its tools to achieve the 3% MB growth rate.

15

After implementing this policy, if the Bank finds that MB is growing too slowly, it can use OM purchases to increase it.

Somewhat later the Bank will begin to see how its policy affects the growth rate of M1. If M1 is growing too fast (say at 7%), the Bank will reduce its open market purchases or make open market sales to reduce the M1 growth rate.

16

Linking Tools to Objectives

Targets and Instruments Operating Instruments

Interest rates or Monetary base

Intermediate targets Monetary Aggregates (M1 , M2)

Objectives Low Inflation, Growth, stable interest rates

17

Central Bank Strategy

18

Money Supply Target

1. M d fluctuates between M d' and M d''

2. With M-target at M*, i fluctuates between i' and i''

Figure 18-2

Hence, a monetary aggregate target involves losing control of i.

19

1. M d fluctuates between M

d' and M d''

2. To set i-target at i* Ms fluctuates between M' and M''

Figure 18-3

Hence, an i target involves losing control of aggregates (monetary aggregates and reserves aggregates).

Interest Rate Target

20

Linking Tools to Objectives

21

Choosing the Targets

The CB has two sets of variables that can be used as targets:

Interest rates (Short and long & T-bill rate) and aggregates (Monetary aggregates and reserve aggregates). Therefore, the targets must have some criteria that the CB can use when choosing one of them as (operating and intermediate) targets. The criteria are:

22

1. Measurability:

Quick and accurate measurement of a target variable is necessary because the target will be useful only if it signals rapidly when the policy is off track. For example, data on monetary aggregates are available after a two-week delay, while interest rate data are available almost immediately. In addition, interest rate data are more precise and rarely revised, this makes interest rates more desirable than monetary aggregates.

23

2. Controllability:

A CB must be able to exercise effective control over a variable if it is to function as a useful target. If the CB cannot control a target, knowing that it is off track is not useful because the CB has no way of getting it on track. For example, the CB has better control over monetary aggregates and interest rates than over nominal GDP (which was suggested as an intermediate target). Thus, nominal GDP is not a good target.

24

3. Predictable Effect on Goals:

The most important characteristic a variable must have to be a good intermediate (operating) target, is that it must have a predictable impact on (intermediate targets) goals.