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

Goals of Monetary Policy 1. Price Stability 2. Economic Growth 3. Low Unemployment 4. Interest Rate Stability 5. Financial Markets Stability 6. Exchange Rate Stability Goals are often in conflict! © 2006 Pearson Addison-Wesley. All rights reserved

Central Bank Strategy © 2006 Pearson Addison-Wesley. All rights reserved

Money Supply Target 1. MD fluctuates between MD' and M D'' 2. With M-target at M*, i fluctuates between i' and i'' © 2006 Pearson Addison-Wesley. All rights reserved

Interest Rate Target 1. MD fluctuates between MD' and MD'' 2. To set i-target at i* MS fluctuates between M' and M'' © 2006 Pearson Addison-Wesley. All rights reserved

Criteria for Choosing Targets Criteria for Intermediate Targets 1. Measurability 2. Controllability 3. Predictability Interest rates aren’t clearly better than Ms on criteria 1 and 2 because hard to measure and control real interest rates. 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. © 2006 Pearson Addison-Wesley. All rights reserved

Taylor Rule Taylor Rule for choosing a target for the federal funds rate: Fed funds rate target = inflation rate + “equilibrium” real fed funds rate + 1/2 (inflation gap) + 1/2 (output gap) Inflation gap = current inflation - target inflation Output gap = percentage deviation of real GDP from potential full-employment GDP © 2006 Pearson Addison-Wesley. All rights reserved

Taylor Rule and Fed Funds Rate © 2006 Pearson Addison-Wesley. All rights reserved