Download Chapter 22 Monetary Policy Strategy

Chapter 22
Monetary Policy Strategy
Indicators of Monetary
Policy
Nominal (usually short-term—Fed Funds) interest rates
Money supply
Since have time lags between policy action and its effect on the ultimate goals, if the
ultimate goals are the only index watched, it is usually too late to make corrective actions if
the desired outcome is not being achieved. Therefore, the Fed watched operating targets.
Operating target is closer to the action than the ultimate target
To be effective operating targets:
Under control of the Fed
Clearly and accurately observable
Closely linked to the ultimate target
If Operating target is Interest Rates:
Problem is that interest rates are indicators of both monetary policy and the
financial conditions in general
If rates are declining--expansionary policy or declining income and prices?
If rates are climbing--restrictive policy or rising income and prices?
Nominal interest rates are frequently affected more by income and price expectations than
by money supply. High or rising interest rates do not so much indicate restrictive policy as
they do rising income and price expectations due to previous expansive monetary policies.
Market rates tend to follow a clear cyclical pattern, rising during periods of economic
expansion and accelerating inflation, and declining during periods of economic contraction
and slowing inflation.
If Operating target is money supply:
Empirical evidence suggests that changes in monetary aggregate captures the future effect
of Fed’s policy: Rising money supply implies Fed expansive policy. Declining money
supply implies a restrictive policy.
Either control MS or interest rates--can't do both
Monetarist—MS
Control money supply then interest rates are volatile
Keynesians--interest rates
Control interest rates then money supply is volatile
Chose of target should depend upon where the disturbance in the economy is coming from:
Financial sector--- interest rates
Real Sector—MS
Assume disturbance is in the financial sector—real sector held constant
Assume set (LM o ) money supply at a given level—therefore no change in the supply of
money by the Fed occurs if demand shifts the curve to LM 1 or LM2
As a result income ranges from Y1 to Y2
On the other hand if the Fed had set interest rates as a target say i0 , then a shift in the
LMo curve to LM1 or LM2 would be offset by equal increases in the money supply by the
Fed actions LM3 to maintain Yo
If disturbance is in the financial sector—interest rate target constrains the change in
income to a narrower range
Disturbance in Real sector-financial sector held constant:
If Fed set (LM o ) money supply at a given level , then shift in the real sector result
in a income range from Y1 to Y2
On the other hand if the Fed had set interest rates as a target say i0 , then a shift in
the IS (real sector), result in an income range from Y'1 to Y'2
If disturbance is in the real sector—money supply target constrains the change in
income to a narrower range
Chose of target should depend upon where the disturbance in the economy is coming from:
Financia l sector--- interest rates
Real Sector—MS
History of Fed. Reserve Targets
Inflation is a concern--Fed has relied on MS as a target
Inflation less of a concern--Fed has relied upon interest rates
The Fed’s game plan
©2000AddisonWesley Longman
Figure 22.1