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Goals and Targets of
Monetary Policy
Lecture 9
Monetary policy
Goals and Targets of Monetary Policy
• The central banks were established to serve as
a lender of last resort to commercial banks.
• The central banks’ monetary tools are used to
control the level of money supply or interest rate.
• However, there is a several objectives which
the central banks try to achieve – all of them
can be potential final goal (target) for
monetary policy
(1) High employment
• targeting 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
• - 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
(3) Price stability
• price stability is very crucial in keeping an
economy function properly
• keeping prices stable also means keeping the
rate of inflation stable because the rise in
inflation means that purchasing power will be
eroded
(4) Interest rate stability
• - interest rate stability is desirable because it
makes borrowing and lending less uncertain for
individuals and businesses
• - if 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.
The ECB is the central bank for Europe's single currency, the euro. The
ECB’s main task is to maintain the euro's purchasing power and thus
price stability in the euro area. The euro area comprises the 16
European Union countries that have introduced the euro since 1999.
Fed Building, Washington, D.C.
Monetary Targets of the central banks
The central banks don’t target the final
goal directly.
• for this purpose the central banks use a
set of variables (known as intermediate
targets) which have direct impacts on the
central banks’ desired goals.
• for example, if the CB wants to slow the
economic activity (to control the economy’s
inflation), it can target the monetary aggregates
(i.e. M0, M1, or M4) or the interest rates (shortterm or long-term)
• in this scenario, the inflation rate (and/or the
economic activity) is the CB’s final monetary
goal, while the monetary aggregates or interest
rates are its intermediate targets
FINAL GOAL (GOALS)
INTERMEDIATE TARGETS
– nominal anchor
(monetary aggregates M1, M2, M3 ..;
interest rates; exchange rate …)
INSTRUMENTS (TOOLS) OF MONETARY
POLICY
Changes in monetary base M0
-
Open market
operations
Discount policy
Reserve
requirements
…
• currency in circulation and the total reserves of banking system make
up the monetary base (MB, monetary aggregate M0 or the primary
money).
MONETARY BASE (M0)
1. Currency in circulation
2. Commercial banks’ deposits
into settlement accounts
3. Required reserves of commercial banks
4. Banks’ cash in vaults
MB = C + R This formula shows the structure of monetary base (M0).
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(2) + (3) + (4) = R (Total reserves of banking system)
How instruments of monetary policy affects monetary base?
• We can classify the monetary base (M0) into two categories:
MB  MB n  DL
where MB n  Non-borrowed monetary base (open market operations)
DL  Borrowed monetary base, i.e. discount loans
• The above formula shows the channels through which the central
bank creates primary money (monetary base, M0).
• Changes in the so called nonborrowed monetary base and borrowed
monetary base - discount loans have also impacts on the proces of
money creation.
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EXAMPLE 1: Suppose the CB decides to buy $1,000 worth of government securities
from the “AB” bank (one of commercial banks).
Central bank
AB bank
Assets
Liabilities
Assets
Liabilities
Securities +$1000
Reserve +$1,000
Securities -$1,000
Reserve +$1,000
EXAMPLE 2: Suppose the CB made a $1,000 loan to “AB” bank through
its discount window.
Central bank
AB bank
Assets
Liabilities
Assets
Liabilities
DL +$1000
Reserve +$1,000
Reserve +$1,000
DL +$1,000
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Total assets
$4,443 billion
on Nov 2, 2016
$Billions
$5,000
$4,000
$3,000
$2,000
$869
billion
Aug.
2007.
Nov.
2008.
Oct.
2010.
Feb.
2013.
Dec.
2014.
Oct.
2016.
Deposits of Depository
Institutions $2,065
billion on Oct 26, 2016
kolovoz
2007.
studeni
2008.
listopad
2010.
veljača
2013.
prosinac
2014.
listopad
2016.
•
Federal (FED) Funds
… typically overnight loans between banks of their deposits at the
Federal Reserve
One reason why bank might borrow in the federal funds is that it
might find it does not have enough deposits to meet the amount required
by regulators
This market is very sensitive to the credit needs of the banks, so the
interest rate on these loans, called the federal funds rate, shows the
tightness of credit market conditions in the banking system and the stance
of monetary policy: when it is high the banks are strepped for funds; when
it is low, bank’ credit needs are low
The federal funds rate in a
target range of ¼ do ½ percent
…
FINAL GOAL (GOALS)
INTERMEDIATE TARGETS
– nominal anchor
(monetary aggregates M1, M2, M3 ..;
interest rates; exchange rate …)
INSTRUMENTS (TOOLS) OF MONETARY
POLICY
Changes in monetary base M0
-
Open market
operations
Discount policy
Reserve
requirements
…
The relationship between the economy’s money supply (M1) and the
monetary base (MB or M0):
M1  m  MB
The money multiplier represents the impact of a $1 change in
the monetary base on the economy’s money supply (M1).
for example, if m = 4 that means a $1 increase in monetary base
will lead to a $4 increase in the money supply
MONETARY BASE
(PRIMARY MONEY, M0)
MONEY SUPPLY (M1)
- Currency in circulation
- Currency in circulation
- Reserves of banking
system at the central bank
- Deposit money (demand
deposits, transactional
deposits on current and giro
accounts of non-monetary
agents
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MONETARY AGGREGATES in the U.S.
On March 23, 2006, the Board of Governors of the Federal Reserve System
ceased publication of the M3 monetary aggregate and its components.
MONEY SUPPLY (M1)
M1 in the U.S. comprises:
(1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of other
depository corporations;
(2) traveler's checks of nonbank issuers;
(3) demand deposits at commercial banks; and
(4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW)
and automatic transfer service (ATS) accounts at depository institutions, credit union
share draft accounts, and demand deposits at thrift institutions.
M2 includes a broader set of financial assets held principally by households.
M2 in the U.S. consists of M1 plus:
(1) savings deposits (which include money market deposit accounts - MMDAs);
(2) small-denomination time deposits (time deposits in amounts of less than
$100,000); and
(3) balances in retail money market mutual funds (MMMFs).
New and specific monetary aggregate for the U.S. is MZM.
Monetary aggregate MZM (Money Zero Maturity) is equal M2 less smalldenomination time deposits plus institutional money funds.
• CB can not 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 CB’s control.
• Suppose the interest rate is estimated to be “i”
and the CB has targeted to control the money
supply so that it stays at Ms.
• Unfortunately, since the money demand is
fluctuating between Md’ and Md‘’, the market
interest rate fluctuates between i’ and i’’.
• As a result, when the CB 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 CB plans to
target the market interest rate at i.
• If the money demand remains at Md, the CB can
achieved the desired market interest rate with
money supply Ms.
• However, since the demand for money
fluctuates between Md’ and Md‘’, the CB has to
constantly adjust the money supply to keep the
interest rate maintain at i.
• As a result, when the CB wants control over the
interest rate, it loses control over the money
supply.
Interest
M's
Ms
M"s
•
i
M"d
Md
M'd
Quantity
Criteria for Choosing Intermediate Targets
• The central banks have to choose either the money
supply or the interest rate as the intermediate target.
• What criteria does the CB use to pick its intermediate
target?
• The CB will pick its intermediate target based on
three criteria: (i) measurability, (ii) controllability, and
(iii) predictable impact on the final goal (goals).
Targeting Money Supply Versus Interest
Rates
The unstable IS curve
fluctuates between IS’ and IS’’ .
The money supply target
produces smaller
fluctuations in output than the
interest rate targets.
Therefore, the money supply
target is preferred.
The unstable LM curve
fluctuates
between LM’ and LM’’.
The money supply target then
produces bigger fluctuations
in output than the interest-rate
target (which leaves output
fixed at Y *).
Therefore, the interest-rate
target is preferred.
FINAL GOAL
INTERMEDIATE TARGET
- The strategy of monetary policy
INSTRUMENTS (TOOLS) OF MONETARY POLICY
Appendix 1:
Central Bank Independence.
57
Basic tasks of central banks are
1.
2.
3.
4.
Formulate, adopt and control national monetary policy
Manage official foreign reserves in a safe and profitable
way
Support and maintain appropriate payment and
settlement systems
Supervise national banking sector
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•
Central bank should also have high level of
independence in setting instruments and goals of
national monetary policy
•
Furthermore, central bank independence is
considered one of the fundaments for the modern
centralbanking policies
59
• Central bank independence is usually defined
as central banks’ autonomy from the government and
budget financing pressures
•
Basically, there are two types of independence
– Economic independence
– Political independence
60
•
ECONOMIC INDEPENDENCE
–
Limited and/or strictly forbidden credit financing of the state –
problems with liquidity or budget deficit must not be solved by
printing money
–
Choice of national monetary policy instruments is especially
important in cases of inplementing the unpopular measures and
instruments
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•
POLITICAL INDEPENDENCE relates to the choice of
governor and board members independent from political
influences and pressures from different lobbies (e.g.
financial or banking sector)
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Monetary policy and
deficit financing
Legal aspect
Price stability
objective
aspect
Central bank
independence
Political
aspect
Exchange rate
policy aspect
Acountability and
transparency aspect
Aspects of central bank independence
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