Transcript Lecture 12

CH 18: Conduct of Monetary Policy
Goals and Targets
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Goals of Monetary Policy

Goals
1. High Employment
 2. Economic Growth
 3. Price Stability
 4. Interest Rate Stability
 5. Financial Market Stability
 6. Foreign Exchange Market Stability
 Goals often in conflict

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High Employment
High employment is a worthy goal for two
reasons:
1. The alternative situation, high unemployment,
causes much human misery, with people
suffering financial distress, loss of personal
self-respect, and  in crime.
2. When u is high, the economy has not only idle
workers but also idle resources, resulting in a
lower GDP.

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Economic Growth
The goal of steady economic growth is closely
related to the goal of low u, because businesses
are more likely to invest in physical capital to 
productivity and growth when u is low.
If u is high and factories are idle, it does not pay
for firms to invest in additional physical capital.
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Hence, policies can be specifically aimed
at promoting economic growth by
directly encouraging firms to invest or
by encouraging people to save, which
provides more funds for firms to invest.
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Price Stability
• In recent years, policymakers have become
increasingly aware of the social and economic
costs of inflation and more concerned with a
stable P as a goal of economic policy.
• In fact, P stability is viewed as the most
important goal for monetary policy because:
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1.
2.
3.
4.
inflation creates uncertainty that may hamper
growth
inflation makes it hard to plan for the future
inflation may damage a country’s social fabric
(by creating conflicts between different groups)
extreme inflation, known as hyperinflation,
leads to slower growth, as for example in
Argentina, Brazil, and Russia in the recent
past.
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Interest-Rate Stability

Interest-rate stability is desirable because
fluctuations in interest rates can create
uncertainty and make it harder (for both firms
and households) to plan for the future.
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Stability of Financial Markets

Financial crises can interfere with the
ability of financial markets to channel funds
from surplus to shortage units, thereby
leading to a sharp contraction in economic
activity.

The promotion of a more stable financial
system in which financial crises are avoided
is thus an important goal for a central bank.
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
The stability of financial markets is also
promoted by i stability because
fluctuations in i create uncertainty for
financial firms, affecting both their
profits as well as their net worth.
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Stability in Foreign Exchange
Markets


The effect of exports and imports
Also, preventing large changes in Ex
makes it easier for firms and people involved
in international trade to plan ahead.
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
Stabilizing extreme movements in E in
Ex markets is thus viewed as a worthy
goal of monetary policy.

In fact, in countries that are even more
dependent on foreign trade, stability in
FX markets takes on even greater
importance.
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Tools
1.
2.
3.
Open market operations.
Discount policy and loans.
Reserve requirements.
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Use of (Operating and Intermediate)
Targets

Suppose that the Bank wants to achieve
a 5% rate of growth for nominal GDP and
is targeting an aggregate (say M1).

If the Bank feels that the 5% nominal GDP
growth rate will be achieved by a 4%
growth rate for M1 (its intermediate target),
which will in turn be achieved by a 3% MB
growth rate (its operating target), it will
use its tools to achieve the 3% MB growth
rate.
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
After implementing this policy, if the
Bank finds that MB is growing too
slowly, it can use OM purchases to
increase it.

Somewhat later the Bank will begin to
see how its policy affects the growth
rate of M1. If M1 is growing too fast (say
at 7%), the Bank will reduce its open
market purchases or make open market
sales to reduce the M1 growth rate.
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Linking Tools to Objectives
Targets and Instruments
 Operating Instruments
 Interest

rates or Monetary base
Intermediate targets
 Monetary

Aggregates (M1 , M2)
Objectives
 Low
Inflation, Growth, stable interest rates
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Central Bank Strategy
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Money Supply Target


Hence, a monetary
aggregate target
involves losing
control of i.
Md
1.
fluctuates
between M d'
and M d''
2. With Mtarget at M*, i
fluctuates
between i' and
i''
Figure 18-2
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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''
Figure 18-3
Hence, an i target
involves losing
control of
aggregates
(monetary
aggregates and
reserves
aggregates).
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Linking Tools to Objectives
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Choosing the Targets
The CB has two sets of variables that
can be used as targets:
 Interest rates (Short and long & T-bill
rate) and aggregates (Monetary
aggregates and reserve aggregates).
Therefore, the targets must have some
criteria that the CB can use when
choosing one of them as (operating and
intermediate) targets. The criteria are:

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1. Measurability:

Quick and accurate measurement of a target
variable is necessary because the target will
be useful only if it signals rapidly when the
policy is off track. For example, data on
monetary aggregates are available after a
two-week delay, while interest rate data are
available almost immediately. In addition,
interest rate data are more precise and rarely
revised, this makes interest rates more
desirable than monetary aggregates.
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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 on track. For example, the CB has better
control over monetary aggregates and
interest rates than over nominal GDP (which
was suggested as an intermediate target).
Thus, nominal GDP is not a good target.
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3. Predictable Effect on Goals:

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.
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