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Chapter 16

Conduct of Monetary Policy: Goals and Targets

In chapter 15 we talked about the tools of monetary policy that the central bank uses in conducting monetary policy.

But why does the CB use these tools? In this chapter we discuss how the CB uses the tools to achieve its ultimate economic goals.

The tools and goals are connected by a number of targets that make it easier for the tools to affect the goals.

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Goals of Monetary Policy1. High Employment Governments aim at reducing unemployment because it means that an important economic resource (labor) is not used efficiently. This results in reducing national income and output (GDP).

2. Economic Growth Economic growth means that more goods and services can be produced in the economy and a higher national income is generated. The government may promote economic growth using monetary policy by encouraging the public to save and businesses to invest.

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3. Price Stability Central banks are concerned with price stability because the alternative is either high inflation or deflation. Price instability has negative economic effects by increasing uncertainty about the future and that may adversely affect economic growth.4. Interest Rate Stability Interest rate stability is important because consumers decisions to buy goods (e.g. houses and cars) and firms decisions to invest (e.g. machines), both depend on their expectations of interest rates. Interest payments represent a significant cost to decision makers.

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5. Stability of Financial Markets The existence of a more stable financial markets helps in avoiding financial crises that affect financial institutions. For example, fluctuations in interest rates produce large capital gains and losses to investors and financial intermediaries holding long term financial instruments such as bonds.6. Stability in Foreign Exchange Markets Because of the increase in trade between countries, fluctuations in exchange rates may result in huge losses for domestic consumers and producers. For example, an increase in the exchange rate makes exports more expensive and negatively affect domestic producers who may cut production and employment. A decline in exchange rate raises imported inflation.

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Central Bank Strategy: Use of Targets

Monetary tools cannot affect the economic goals directly. Thus, the CB uses a number of monetary variables that lie between them, called targets.The strategy is as follows:

1) The CB selects one or more economic goals,

2) The CB chooses variables called intermediate targets, such as monetary aggregates (e.g. M1, M2) or interest rates (short or long term), which have a direct effect on the goals.However, even these variables are not directly affected by the tools.

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3) Then, the CB chooses a number of variables called operating targets, they can be either monetary aggregates (e.g. reserves, monetary base), or interest rates (e.g. interbank rate and T-bill rate). These targets are more responsive to the tools.

Advantage of Targets An advantage of using monetary targets is to get a quick evaluation that the tools are on the right path that the CB desires. This is much better than waiting to see the effect on the goals which takes a much longer time.

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Central Bank Strategy

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Criteria for Choosing Targets The CB has two sets of variables that can be used as monetary targets:

Interest rates (Short and long & T-bill rate & interbank rate) and monetary aggregates (Reserves & Monetary base & Money supply)

Therefore, the targets must have some criteria that the CB can use when choosing them as (operating and intermediate) targets. The criteria are:

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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 diverts from the desired direction.

Quick: monetary aggregates data are available after a two-week delay, while interest rate data are available almost immediately. Accurate: monetary aggregates data are frequently revised and corrected, while interest rate data are more precise and rarely revised. This makes interest rates more preferable than monetary aggregates, according to this criterion.

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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 back on track. 3. PredictabilityThe 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.

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Money Supply Target

1. M d fluctuate between M d' and M

d''

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

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Interest Rate Target

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

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

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Federal Funds Rate and MoneyGrowth Before and After October 1979

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