1. Conduct of Monetary Policy: Goals and Targets
Chapter 18
Conduct of Monetary Policy: Goals and Targets

2. Goals of Monetary Policy
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
© 2004 Pearson Addison-Wesley. All rights reserved

3. Central Bank Strategy
© 2004 Pearson Addison-Wesley. All rights reserved

4. 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''
© 2004 Pearson Addison-Wesley. All rights reserved

5. 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''
© 2004 Pearson Addison-Wesley. All rights reserved

6. The incompatibility of i and M targets
Interest-rate and monetary aggregate targets are incompatible.
A central bank can hit one or the other but not both.
© 2004 Pearson Addison-Wesley. All rights reserved

7. Criteria for Choosing Targets
Criteria for Intermediate Targets
Measurability
Quick and accurate
Monetary aggregates with two-week delay, interest-rate available immediately, and GDP less accurate and long-time delay.
Is i target better? Not necessary. We care ir, but it is hard to measure because of expected π.
Controllability
Is i target better? Not necessary.
Predictably Effect on Goals
Interest rates aren’t clearly better than Ms on criteria 1 and 2 because hard to measure and control real interest rates
© 2004 Pearson Addison-Wesley. All rights reserved

8. Criteria for Choosing Targets
Criteria for Operating Targets
Same criteria as above
Reserve aggregates and interest rates about equal on criteria 1 and 2.
For 3, if intermediate target is Ms, then reserve aggregate is better; if the desired intermediate target is an interest rate, the preferred operating target will be federal funds rate.
© 2004 Pearson Addison-Wesley. All rights reserved

9. Taylor Rule, NAIRU and the Phillips Curve
Fed funds rate target = inflation rate +
equilibrium real fed funds rate +
1/2 (inflation gap) +
1/2 (output gap)
Taylor has assumed that equilibrium real fed funds rates (consistent with full employment in the long run) is 2% and that an appropriate target for inflation would be also 2%, with equal weights of ½ on the inflation and output gaps.
Example: π=3% , and GDP was 1% above its potential. Then Taylor rule suggests that Fed funds rate should be set at 6%.
© 2004 Pearson Addison-Wesley. All rights reserved

10. Taylor Rule, NAIRU and the Phillips Curve
Phillips Curve Theory
Change in inflation influenced by output relative to potential, and other factors
When unemployment rate < NAIRU, inflation rises
NAIRU thought to be 6%, but inflation falls with unemployment rate below 5%
Phillips curve theory highly controversial
Potential GDP is a function of the natural rate of unemployment, which is consistent with full employment
Nonaccelerating inflation rate of unemployment (NAIRU): the rate of unemployment at which there is no tendency for inflation to change.
© 2004 Pearson Addison-Wesley. All rights reserved

11. Taylor Rule and Fed Funds Rate
© 2004 Pearson Addison-Wesley. All rights reserved