PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 25 Objectives and Targets of Monetary Policy

Copyright © 2004 South-Western. All rights reserved.25–2 Fundamental Issues 1.What are the ultimate goals of monetary policy? 2.Why might a central bank use an intermediate monetary policy target? 3.What are the pros and cons of interest rates versus monetary aggregates as intermediate monetary policy targets? 4.What is the policy assignment problem?

Copyright © 2004 South-Western. All rights reserved.25–3 Internal Goals of Monetary Policy Inflation goals:  Low/no inflation with limited year-to-year variability. Output goals:  High and stable economic (GDP) growth. Employment goals:  Stable employment growth with low unemployment. Legislated goals:  Employment Act of 1946  Humphrey-Hawkins Act of 1978

Copyright © 2004 South-Western. All rights reserved.25–4 External Goals of Monetary Policy Balanced international trade:  Domestic consumption of domestic output  Spending of real income on imports  Promotion of exports  Exchange rate considerations

Copyright © 2004 South-Western. All rights reserved.25–5 Key Term Mercantilism:  The idea that a primary determinant of a nation’s wealth is international trade and commerce, so a nation can gain by enacting policies that spur exports while limiting imports.

Copyright © 2004 South-Western. All rights reserved.25–6 The Costs of Inflation and Inflation Variability Table 25–1 Type of Cost Resources expended to economize on money holdings (more trips to banks, etc.) Costs of changing price lists and printing menus and catalogues Redistribution of real incomes from individuals to the government Reductions in investment, capital accumulation, and economic growth Slowed pace of introduction of new and better products Redistribution of resources from creditors to debtors Cause Rising prices associated with inflation Individual product/service price increases associated with inflation Inflation that pushes people into higher, nonindexed nominal tax brackets Inflation variability that complicates business planning Volatile price changes that reduce the efficiency of private markets Unexpected inflation that reduces the real values of debts

Copyright © 2004 South-Western. All rights reserved.25–7 Intermediate Targets of Monetary Policy Intermediate target:  An economic variable that a central bank seeks to control because it determines that doing so is consistent with its ultimate objectives. The rationales for intermediate targeting:  Difficulty in reaching agreement about the specific effects of monetary policy.  The limited long-term information about the economy available to policymakers.

Copyright © 2004 South-Western. All rights reserved.25–8 Inflation Targeting in New Zealand and Canada Figure 25–1 SOURCES: Bank of New Zealand and Bank of Canada.

Copyright © 2004 South-Western. All rights reserved.25–9 The Intermediate Targeting Strategy for Monetary Policy Figure 25–2

Copyright © 2004 South-Western. All rights reserved.25–10 Choosing an Intermediate Target Variable Characteristics:  Frequently observable  Consistency with ultimate goals  Definable and measurable  Controllable Potential variables:  Monetary aggregates  Credit aggregates  Interest rate  Nominal GDP  Exchange rates

Copyright © 2004 South-Western. All rights reserved.25–11 Targeting the Nominal Interest Rate in the Face of Money Demand Variations Figure 25–3

Copyright © 2004 South-Western. All rights reserved.25–12 Targeting the Nominal Interest Rate in the Face of Variations in Autonomous Expenditures Figure 25–4

Copyright © 2004 South-Western. All rights reserved.25–13 Targeting the Quantity of Money in the Face of Variations in Autonomous Expenditures Figure 25–5

Copyright © 2004 South-Western. All rights reserved.25–14 Targeting the Quantity of Money in the Face of Money Demand Variations Figure 25–6

Copyright © 2004 South-Western. All rights reserved.25–15 Interest Rates Versus Monetary Aggregates As Intermediate Monetary Policy Targets Nominal interest rate target:  Stabilizes aggregate demand if money demand is highly volatile while aggregate desired expenditures are relatively stable. Monetary target:  Makes aggregate demand more stable if aggregate desired expenditures are variable while money demand is relatively stable.

Copyright © 2004 South-Western. All rights reserved.25–16 Exchange Rate Targeting Assignment problem:  The problem of determining whether monetary or fiscal policymakers should assume responsibility for achieving either external-balance or internal- balance objectives.  As a result, efforts by central banks to vary exchange rate targets and by governments to conduct fiscal policy can conflict, causing neither policymaker to achieve its ultimate economic goals.

Copyright © 2004 South-Western. All rights reserved.25–17 Monetary and Fiscal Policy Combinations for External Balance Figure 25–7

Copyright © 2004 South-Western. All rights reserved.25–18 Monetary and Fiscal Policy Combinations for Internal Balance Figure 25–8

Copyright © 2004 South-Western. All rights reserved.25–19 Policy Assignments for Internal and External Balance Figure 25–9

Copyright © 2004 South-Western. All rights reserved.25–20 Targeting Nominal GDP Figure 25–10