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Chapter 16
Conduct of Monetary Policy:
Goals and Targets
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In chapter 15 we talked about the tools of monetary
policy that the central bank uses in conducting
monetary policy.
But why does the CB use these tools?
In this chapter we discuss how the CB uses the tools
to achieve its ultimate economic goals.

The tools and goals are connected by a number of
targets that make it easier for the tools to affect the
goals.

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Goals of Monetary Policy
1. High Employment
 Governments
aim at reducing unemployment
because it means that an important economic resource
(labor) is not used efficiently.
 This results in reducing national income and output
(GDP).
2. Economic Growth
 Economic growth means that more goods and
services can be produced in the economy and a higher
national income is generated.
 The government may promote economic growth
using monetary policy by encouraging the public to
save and businesses to invest.
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3. Price Stability
 Central banks are concerned with price stability
because the alternative is either high inflation or
deflation.
 Price instability has negative economic effects by
increasing uncertainty about the future and that may
adversely affect economic growth.
4. Interest Rate Stability
 Interest
rate stability is important because
consumers decisions to buy goods (e.g. houses and
cars) and firms decisions to invest (e.g. machines),
both depend on their expectations of interest rates.
 Interest payments represent a significant cost to
decision makers.
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5. Stability of Financial Markets
 The existence of a more stable financial markets
helps in avoiding financial crises that affect financial
institutions.
 For example, fluctuations in interest rates produce
large capital gains and losses to investors and financial
intermediaries holding long term financial instruments
such as bonds.
6. Stability in Foreign Exchange Markets
 Because of the increase in trade between countries,
fluctuations in exchange rates may result in huge losses
for domestic consumers and producers.
 For example, an increase in the exchange rate makes
exports more expensive and negatively affect domestic
producers who may cut production and employment.
 A decline in exchange rate raises imported inflation.
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Central Bank Strategy: Use of Targets
Monetary tools cannot affect the economic goals
directly. Thus, the CB uses a number of monetary
variables that lie between them, called targets.
The strategy is as follows:
1) The CB selects one or more economic goals,
2) The CB chooses variables called intermediate
targets, such as monetary aggregates (e.g. M1, M2) or
interest rates (short or long term), which have a direct
effect on the goals.
However, even these variables are not directly affected
by the tools.
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3) Then, the CB chooses a number of variables called
operating targets, they can be either monetary
aggregates (e.g. reserves, monetary base), or interest
rates (e.g. interbank rate and T-bill rate).
These targets are more responsive to the tools.
Advantage of Targets
An advantage of using monetary targets is to get a
quick evaluation that the tools are on the right path
that the CB desires.
 This is much better than waiting to see the effect on
the goals which takes a much longer time.

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Central Bank Strategy
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Criteria for Choosing Targets
The CB has two sets of variables that can be used as
monetary targets:

Interest rates (Short and long & T-bill rate &
interbank rate) and monetary aggregates (Reserves &
Monetary base & Money supply)

Therefore, the targets must have some criteria that
the CB can use when choosing 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 diverts from the desired
direction.
Quick: monetary aggregates data are available after
a two-week delay, while interest rate data are available
almost immediately.
 Accurate: monetary aggregates data are frequently
revised and corrected, while interest rate data are more
precise and rarely revised.

This makes interest rates more preferable than
monetary aggregates, according to this criterion.

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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 back on track.

3. Predictability
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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Money Supply Target
1. M d fluctuate between M d' and
M d''
2. With M-target at M*, i
fluctuates between i' and i''
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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''
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Federal
Funds Rate
and Money
Growth
Before and
After
October
1979
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