Conducting Monetary Policy: Goals and Targets

Originally, the Fed was set established to serve as a lender of last resort to commercial banks (after a series of bank panics in the U.S.), i.e. operating the discount window. Since then the Fed has been given two more monetary tools to control the money supply: open market operation and reserve requirements.

The Fed’s monetary tools are used to control the level of money supply (or interest rate). However, what are some of the objectives the Fed is trying to achieve? Since its original inception, the Fed has been given the responsibility to help achieve the following goals with its monetary tools.

(1) High employment Two acts have been passed (the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978) which committed the U.S. government in achieving high employment with stable prices.

Rather than understanding why it is important to have high unemployment, it is easier to understand why it is important not to have high unemployment. High unemployment is usually associated with human misery and idle resources.

Should it be the Fed’s goal to achieve zero unemployment? It is not necessarily favorable to an economy to have no unemployment at all. Frictional unemployment (i.e. individuals that are unemployed during a career change, life style change, etc. ) is actually beneficial. As a result, it is more important for the Fed to target the natural rate of employment, i.e. the level of employment where the demand of labor equals the supply of labor. However, estimating the natural rate of employment (or unemployment) is very difficult.

(2) Economic growth Economic growth and the level of employment go hand in hand. High economic growth usually leads to high level of employment. However, economic growth and employment can be stimulated with different policies. Economic growth can be stimulated by providing companies incentive to invest in new projects. This can be done through low interest and/or tax incentives.

Chapter 12-1 (3) Price stability Price stability is very crucial in keeping an economy function properly. Fluctuating prices make decision making very difficult for businesses and owners. In addition, keeping prices stable also means keeping the rate of inflation stable. If you remember, rising inflation means that purchasing power will be eroded. The German Central Bank has adopted a very strict anti- inflation monetary policy.

(4) Interest rate stability Interest rate stability is desirable because it makes borrowing and lending less uncertain for individuals and businesses. As interest rate becomes more volatile, individuals and businesses will be less willing to borrow or lend.

(5) Stability of the financial markets The degree of development of a country is usually measured by the degree of development of its financial market. A highly sophisticated financial market eases the exchange of resources (or funds) from lenders to borrowers. An unstable financial market will slow down the transfer of such funds, which in turn will lead to slower economic growth.

(6) Stability in the foreign exchange market The prosperity of a country depends heavily on its foreign trades and investments with other countries. Trading allows a country to specialize in certain products and services (which will lead to a higher level of output), and investments will attract funds from other countries. However, the flow of trades and investments depends heavily on the stability of the foreign exchange market. A volatile foreign exchange market will usually lead to a drop in foreign trades and investments.

The goals listed above can all be achieved in the long-run, but there might be some conflict in the short-run. For example, the economy is growing which means that businesses are investing more in capitals and unemployment is falling. However, the increase in economic activity might raise the level of inflation if insufficient goods and services are produced to meet the demand, and the level of interest rate will start rising.

Monetary Targets of the Fed

Chapter 12-2 The objective of the Fed is to achieve the goals listed above with its monetary tools. However, the Fed does not target those goals directly, because it usually take a while (i.e. lag) to see the impact of its policy. If the policy is not on target, it will be too late for the Fed to go back to change its policy. As a result, the Fed aims to influence a set of variables (known as intermediate targets) which have direct impacts on the Fed’s desired goals. For example, if the Fed wants to slow the economic activity (to control the economy’s inflation), it can target the monetary aggregates (i.e. M1, M2 or M3) or the interest rates (short-term or long-term). In this scenario, the economic activity and inflation rates are the Fed’s monetary goals, and the monetary aggregates and interest rates are its intermediate targets.

Once the Fed has identify its intermediate targets, it influences them by targeting the operating targets which it can better manipulate with its monetary tools. Some examples of the Fed’s operating targets are reserve aggregates (reserves, non-borrowed reserves, monetary base, etc.) and interest rates (federal funds rates and T-bill rates).

It is easier for the Fed to aim for the operating and intermediate targets than the goals because it can see the results much faster and judge whether its policies are on the right track. If they are not, the Fed will adjust them (using mostly OMO) to push them back on track.

How does the Fed go about implementing its monetary policy? First, the Fed needs to identify its goals (e.g. an economic growth of 5%). Based on its research, the Fed knows that this goal can be achieved with a 4% increase in M2, which can be accomplished with a 2% increase in monetary base (i.e. OMO purchase). Since the effect of the OMO on the monetary base can be determined very quickly, the Fed will know if its OMO is successful in stimulating a 2% increase in monetary base. If the monetary base is not growing fast enough, it can stimulate it by conducting more OMO purchase. And if the monetary base is growing too quickly, the Fed can slow it down by conducting some OMO sale.

Once the Fed has reached its operating target of having a 2% increase in monetary base, it will need to determine if the M2 is growing at the target rate of 4%. If the M2 is not responding as well as the Fed has hoped (e.g. a 3% increase) to a 2% increase in monetary base, the Fed will boost the monetary base growth rate. On the other hand, if the M2 is responding too well to a 2% increase in monetary base, the Fed will slow the growth rate of the monetary base.

Chapter 12-3 (1) Choosing its Intermediate Targets As we have mentioned earlier, the Fed can target the reserve aggregates and the interest aggregates. However, the Fed can only target one of them and not both at the same time. In other words, the Fed cannot control the money supply and the interest rate at the same time. The reason for that is because the demand for money is out of the Fed’s control. Lets look at this more carefully.

Suppose the demand for money is estimated to be M d and the Fed has targeted to control the money supply so that it stays at M . Unfortunately, since the money demand is fluctuating between M d and M d , the market interest rate fluctuates between i and i . As a result, when the Fed wants control over the money supply, it loses control over the interest rate.

Interest Ms

i

" M d

Md

' M d Quantity

On the other hand, suppose the Fed plans to target the market interest rate at i . If the money demand remains at M d , the Fed can achieved the desired market interest rate with money supply

M s . However, since the demand for money fluctuates between M d and M d , the Fed has to constantly adjust the money supply to keep the interest rate maintain at i . As a result, when the Fed wants control over the interest rate, it loses control over the money supply.

Chapter 12-4 ' " Interest M s Ms M s

i

" M d

Md

' M d Quantity

(2) Criteria for Choosing Intermediate Targets We know that the Fed has to choose either the money supply or the interest rate as the intermediate target. What criteria does the Fed use to pick its intermediate target? The Fed will pick its target based on three criteria: (i) measurability, (ii) controllability, and (iii) predictable impact on the goals.

Chapter 12-5