Chapter 16 What Should Central Banks Do? Monetary Policy Goals, Strategy, and Targets

Introduction -- Chapter 15 involves the tools of monetary policy that the central bank uses in conducting monetary policy. -- But why does the CB use these tools? -- Monetary policy tools are used to achieve its ultimate economic goals through monetary targets . -- The tools and goals are connected by a number of targets that make it easier for the tools to affect the goals.

Goals of Monetary Policy 1. 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. The government may promote economic growth using monetary policy by encouraging the public to save and businesses to invest.

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.

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. While a decline in the exchange rate raises imported inflation.

Conducting Monetary Policy How Monetary Policy is Done? Diagram

Monetary tools cannot affect the economic goals directly 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: The CB selects one or more economic goals, 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.

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.

Time Inconsistency Monetary policy is often crafted to produce a long run outcome, however, the actions needed to achieve the long run goal may not be the best choices in the short run. Such policies are time inconsistent … we do not consistently follow the plan over time. Such a plan will almost always be abandoned.

Examples of Time Inconsistency To reduce expected inflation: ..the central bank announces its tighten monetary policy (through money supply target). …But faced with high unemployment, the central bank may be tempted to cut interest rates and which may create volatility in the financial markets. To stimulate economic growth: ..the central bank announces its expansionary monetary policy (through money supply target). …But faced with high inflation, the central bank may be tempted to rise interest rates.

Monetary Policy Targets CB attempts to control either the money supply (monetary target), or interest rate (interest rate target) to achieve the goals. Can the CB control both at the same time to achieve the goal?

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''

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''

Criteria for Choosing Targets -The criteria for Intermediate and Operating Targets: 1. Measurability: Accurate: monetary aggregates data are frequently revised and corrected, while interest rate data are more precise and rarely revised. Quick: monetary aggregates data are available after a two-week delay, while interest rate data are available almost immediately. Result: This makes interest rates aggregates more preferable than monetary aggregates, according to this criterion.

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. Result: for operating targets, controllability is more important. 3. Predictability 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.

Monetary Targeting Advantages Disadvantages To achieve price stability, the CB announces that it will target an annual growth rate in a particular monetary aggregate (M1, M2). Once the rate is set, the CB is responsible for hitting this target. This policy is Flexible, transparent, accountable. Advantages Almost immediate accountability. Almost immediate signals help fix inflation expectations and produce less inflation. Disadvantages Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate.

Inflation Targeting -Why not directly target inflation??. With inflation target, the CB makes public announcement of the inflation target. -Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal. -Many information are used in making decisions. -Increased transparency of the strategy. -Increased accountability of the central bank.

Inflation Targeting Advantages Disadvantages Does not rely on one variable to achieve target Easily understood Reduces potential of falling in time-inconsistency trap Stresses transparency and accountability Disadvantages Delayed signaling Too much rigidity Potential for increased output fluctuations Low economic growth during disinflation

Implications of Monetary & Inflation Targets Monetary Targeting (…i.e. USA, Japan.) -Case of USA Monetary targeting, particularly fed announces iff operating target. Inflation Targeting (…i.e. New Zealand (3-5%), Canada (1-3%), EU (2%), UK(2.5%)) -Case of Canada Incorporating short term- i & exchange rate for Canadian dollar.