Monetary Policy Goals
The goal of monetary policy
is to increase the well-being of society. The well-being is measured in
terms of the quantity and quality of goods and services that people
consume. The Fed has six monetary policy goals: Price
stability, high employment, economic growth, financial market &
institution stability, interest rate stability, and foreign-exchange rate
Price stability - product prices are very important, because they communicate
information to households and businesses. Households determine how much
goods to buy, while businesses determine how much goods to produce.
Inflation is a persistent increase in prices of goods and services and
inflation erodes the value of money. The higher the inflation rate
becomes, the more variable it becomes. This variability causes
uncertainty for businesses, consumers, workers, which can lead to
adverse effects on decisions and lead to lower economic activity. If the
inflation rate becomes too high, then money's functions of a "store of
value" and "medium of exchange" breaks down.
High employment - the Fed and Federal government try to lower unemployment as
much as possible, because high unemployment causes human misery and
causes workers to be idle, factory space and equipment are
underutilized. When a society does not use all its resources, then the
economy's GDP will grow at a slow rate or even decrease. It is
impossible to lower unemployment to zero, because some workers quit
their jobs and look for new ones and students graduate and enter the
labor market. The Fed tries to lower the unemployment rate to the
natural rate of unemployment. Currently, economists estimate the natural
rate of unemployment to be approximately 6% for the United States. If
the Fed strives for an unemployment rate less than 6%, then the Fed's
policy results in inflation.
Economic growth - when the economy is growing, real GDP is increasing,
indicating that society is producing more goods and services. A high
real GDP growth rate causes the unemployment rate to decrease and
businesses earn profits and increase investment, causing more goods and
services to be produce. Another important benefit when real GDP is
strongly growing is income increases for businesses and households. When
businesses and households have higher incomes, the local, state, and
federal governments collect more tax revenue. The Fed uses its monetary
policy to encourage strong economic growth.
Financial market and institution stability - financial panics, bank runs, stock
market crashes, or a large financial institution bankrupts can cause a
chain reaction that causes other financial institutions to bankrupt. The
link between savers and investors will be severed. Businesses will not
receive loans they need to invest and customers will not receive loans
to buy homes, cars, and other assets. When the financial market and
institutions break down, then the economy can enter into a recession,
causing high unemployment and slow or negative GDP growth rates. The Fed
stabilizes the financial system by being a "lender of the last resort"
to prevent financial panics.
stability - the Fed stabilizes the interest rates, because
fluctuations in interest rates can create uncertainty in the economy and
makes it more difficult to plan for the future. Businesses will be
uncertain about investing in new buildings, machines, and equipment.
Consumers will be uncertain about long-term investments, such as buying
a house or car. Interest rate stability is related to the stability of
the financial markets. Large swings in interest rates can cause large
capital gains and losses in the financial markets. Some investors will
earn profits, while others earn losses.
market stability - the Fed tries to stabilize the value of the
U.S. dollar to other major currencies, such as the Japanese Yen and
German Deutsche Mark . A strong U.S. dollar causes products made in the
United States to be more expensive to foreigners while foreign made
products become cheaper to U.S. citizens. Consumers will buy the cheaper
foreign products, causing imports to rise, while U.S. businesses sell
less products abroad, causing exports to decrease. If the U.S. dollar
becomes weaker, you get the exact opposite. The products made in the
U.S. become cheaper to foreigners, while foreign made goods become more
expensive. U.S. exports increase while imports decrease.
Some of these goals conflict with each other. For example, if the FED pursues monetary
policy that expands the money supply to cause national output to increase
and unemployment to decrease. This monetary policy can cause higher
inflation and the nominal interest rates increase, because of the higher
expectations of inflation (i = r + pe).
How Time Lags Complicate Monetary Policy
The Fed cannot influence the
monetary policy goals directly. The Fed uses its tools - open market
operations, discount rates, and reserve requirements to indirectly
influence the monetary policy goals. However, two time lags occur, which
makes implementing monetary policy very difficult.
Information lag - for the Fed or government to do anything, it needs data and
information. It needs fast data, but some data like the unemployment
rate and GDP data takes months to collect. The economy could be in a
recession, but it will not be reflected in the statistics for several
Administrative lag - once the Fed has
information, the Fed requires time to study the information
and design and approve a policy.
Impact lag - there is a time delay when the policy is implemented and has
an impact on the economy.
These time lags can cause
problems. For example, if it takes the Fed 6 months to detect that the
economy is in a recession and 1 year for monetary policy to have an impact
on the economy, then it takes the Fed 1 � years to mitigate the effects of
the recession. If this recession lasted only 1 year and the economy
naturally returns to the full employment level, then the Fed's policy will
take effect and create inflation. The Fed's intervention may make the
economy more unstable.
Reducing the Time Lag Problem
The Fed uses two targets to reduce the problems with time lags.
Intermediate targets - The intermediate targets are the M1, M2, and M3
definitions of the money supply and short-term interest rates. The Fed
will use its tools to influence the intermediate targets. These
intermediate targets directly affect the price level, unemployment rate,
economic growth rate, etc. The Fed has more control over the
intermediate targets and the time lags are shorter.
Operating targets - The Fed has even more control over operating targets than
intermediate targets. Operating targets are the federal funds rate and
nonborrowed reserves. The federal funds rate is the interest rate that
banks charge for lending their excess reserves to other banks. When the
Fed uses open markets operations, change discount policy, or change
reserve requirement, then the Fed's monetary policy has an immediate
impact on the federal funds rate and nonborrowed reserves. When the Fed
implements monetary policy, such as a higher GDP growth rate, the Fed's
policy immediately affects the operating targets. The operating targets
in turn influence the intermediate targets, and the intermediate targets
influence the policy goals, such as higher GDP growth rate. The Fed
monitors changes in the intermediate and operating targets and determine
if the monetary policy is having the correct affect.
The Fed has three criteria for selecting intermediate targets.
Measurability - the intermediate target must be
easily measured and quickly observed to overcome information lags.
Controllability - the Fed has to sufficiently
control the intermediate target to overcome the impact lag. For example,
the Fed can influence the money supply, but not the GDP growth rate.
There are many factors that influence the GDP growth rate and the Fed
cannot influence all of them. Therefore, GDP will never be selected as
an intermediate target.
Predictability - the Fed needs to have
intermediate targets that have a predictable impact on the policy goals.
For example, if the Fed influences the M1 definition of the money supply
and M1 sometimes influence the unemployment rate and other times do not,
then M1 would not be a good intermediate target.
Monetary Policy and Economic Instability
Since the 1990s, the Fed has
emphasized a goal of low inflation and has been successful. Europe and
Japan also emphasize price stability and low inflation rates. Before the
1990s, the Fed switched back and forth between interest rate and money
supply targets. The Fed was not successful, because the Fed's monetary
policy causes more instability in the economy. Economists refer this to
procyclical monetary policy. For example, the Fed selects
interest rates as its intermediate target. When an economy is growing
rapidly, interest rates tend to increase. For the Fed to lower the
interest rates, it has to buy more U.S. government securities. The price
of the securities increase, causing interest rates to decrease. However,
bank reserves increase, the money supply increases, and a larger money
supply can cause the economy to grow faster. If the economy entered into a
recession, the interest rates tend to decrease. For the Fed to increase
the interest rates, it has to sell U.S. government securities. The price
of the securities decrease, causing the interest rate to increase.
However, bank reserves decrease, the money supply decreases, and
decreasing the money supply can cause the recession to become
Economists have suggested that the Fed use other intermediate targets.
Nominal GDP - if an economy produces more goods and services, then both real and
nominal GDP increase. If inflation causes higher prices, the higher
prices have no impact on real GDP, but nominal GDP increases. Some
economists believe the Fed cannot influence real GDP. However, the Fed
can influence the inflation rate which in turn influences the nominal
GDP. If the Fed selected nominal GDP as an intermediate target, then the
Fed would be focusing on price stability.
Yield curve - the Fed examines the yield curve, but the shape of the yield
curve depends on expectations of inflation and real interest rates.
Commodity prices - commodity prices do not accurately predict inflation well.
Foreign-exchange rate of the U.S. dollar - exchange rates to some degree predict
inflation and real GDP growth rate, but the exchange rate may be
responding to changes in the interest rate.