CH 18: Conduct of Monetary Policy

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CH 18 Conduct of Monetary Policy

• Goals and Targets

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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

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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.

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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.
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• 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.

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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

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• inflation creates uncertainty that may hamper
  growth
• inflation makes it hard to plan for the future
• inflation may damage a countrys social fabric
  (by creating conflicts between different groups)
• extreme inflation, known as hyperinflation, leads
  to slower growth, as for example in Argentina,
  Brazil, and Russia in the recent past.

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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.

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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.

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• 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.

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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.

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• 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.

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Tools

• Open market operations.
• Discount policy and loans.
• Reserve requirements.

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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.

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• 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.

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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

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Central Bank Strategy
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Money Supply Target
Hence, a monetary aggregate target involves
losing control of i.

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

• 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
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Linking Tools to Objectives
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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

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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
  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.

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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 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.

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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.