1. Copyright © 2002 Pearson Education, Inc. Goals of Monetary Policy Price stability High employment Economic growth Financial market and institution stability Interest rate stability Foreign-exchange market stability

2. Copyright © 2002 Pearson Education, Inc. Problems in Achieving Monetary Policy Goals: Tools and Targets The goals may not be simultaneously achievable. Lots of goals … just a few tools: [Open market operations, discount rate, reserve requirements] These tools don’t let it achieve its goals directly. Fed also has timing problem using its policy tools. The Fed uses targets to achieve its goals Short-term interest rates Monetary aggregates M1 growth, M2 growth

3. Copyright © 2002 Pearson Education, Inc. Slide 21-3 Figure 21.1 Achieving Monetary Policy Goals

4. Copyright © 2002 Pearson Education, Inc. Types of Targets Intermediate targets: financial variables that impact economic behavior and help the Fed achieve its goals. Short-term interest rates Monetary Aggregates: M1, M2 Operating targets: variables that the Fed controls directly with monetary policy tools Fed funds rate, Nonborrowed reserves, Borrowed reserves Operating targets must be closely related to intermediate targets  Fed funds rates  Short-term interest rates  Real rates ??  Nonborrowed reserves  M1 ???  Output and prices ???

5. Copyright © 2002 Pearson Education, Inc. Slide 21-5 The Targeting Dilemma: Money Supply or Interest Rates? Money Supply Targeting and Interest Rate Fluctuations

6. Copyright © 2002 Pearson Education, Inc. Slide 21-6 The Targeting Dilemma: Money Supply or Interest Rates? Interest Rate Targeting and Money Supply Fluctuations

7. Copyright © 2002 Pearson Education, Inc. The Monetary Policy Record After 1951, short-term interest rates and free reserves were intermediate targets. Free Reserves = Excess Reserves – Borrowed Reserves In the 1970s, money was the intermediate target and interest rate the operating target. 1979-1982 Volcker Disinflation: nonborrowed reserves became the stated operating target. After 1982, the Fed began to pay more attention to the federal funds rate.

8. Copyright © 2002 Pearson Education, Inc. The Monetary Policy Record Exchange rate changes shaped Fed policymaking more during the 1980s and 1990s than before Plaza Accord, September 1985: Bring’n’ down dollar Louvre Accord February 1987: Propp’n’ up dollar  The bubble economy? Taylor’s Rule Funds Rate Target = Inflation + Real Equil Fed Funds Rate + ½ {Inflation Gap} + ½ {Output Gap} Inflation Targeting State and adhere to credible medium run inflation objective Adjust in short run to stabilize output, financial markets, exchange rate, etc.

9. Copyright © 2002 Pearson Education, Inc. Slide 21-9 Fed Funds Rate and Money Supply Growth Rate, 1979-2000

10. Copyright © 2002 Pearson Education, Inc. Reevaluating Fed Targeting Policy Variables other than money may be useful as indicators. Nominal GDP growth rate Yield curve slope. Commodity prices … unlikely to be good indicator. Exchange rate movements … a useful indicator if combined with others Federal Funds Rate – Market Short Rate Spread Quest for an automatic stabilizer