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Lesson 16: The Conduct of Monetary Policy

Upon completion of this lesson, you should be able to do the following:

  • Identify the Fed's six monetary policy goals.
  • Describe how time lags complicate monetary policy.
  • Explain how the Fed chooses targets in order to reduce the problem with time lags.
  • Explain how the Fed's monetary policy may cause the economy to become more unstable.

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 stability.

  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. Interest rate 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.

  6. Foreign-exchange 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.

  1. 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 months.

  2. Administrative lag - once the Fed has information, the Fed requires time to study the information and design and approve a policy.

  3. 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.

  1. 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.

  2. 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.

  1. Measurability - the intermediate target must be easily measured and quickly observed to overcome information lags.

  2. 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.

  3. 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 worse.

Economists have suggested that the Fed use other intermediate targets.

  1. 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.

  2. Yield curve - the Fed examines the yield curve, but the shape of the yield curve depends on expectations of inflation and real interest rates.

  3. Commodity prices - commodity prices do not accurately predict inflation well.

  4. 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.


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