Goals of the Federal ReserveDual MandateAchieve two coequal objectives – price stability and high employment (economic growth will follow)Other goals of the Federal ReserveStability of financial marketsInterest-rate stabilityStability in foreign exchange marketsConflict among goalsAchieving price stability may worsenemployment or interest-rate stability in the short run.Hierarchical MandatePut the goal of price stability first andthen as long as it is achieved other goals can be pursued.Price stability should be the primary long-run objective, not necessarily primary for the short-run if concerned about high unemployment.Nominal anchor Nominal variable like the inflation rate or money supply which ties down the price level to help achieve price stability.Having a nominal anchor limits the time-inconsistency problem.What is the time-inconsistency problem? Think about the example of a whiny child.Inflation TargetingAnnouncing specific numerical targets for the inflation rate.AdvantagesUse all available information to determine monetary policyReadily understood by public; highly transparentIncreased accountability of central bankReduces likelihood of time-inconsistency problemDisadvantagesDelayed signaling – long lags for monetary policyToo much rigidityPotential for increased output fluctuationsPotential for low economic growthThe Federal Reserve’s Monetary Policy Strategy – “Just-Do-It”Forward looking and preemptive.AdvantagesUses all available informationDemonstrated successDisadvantagesLack of transparencyLow accountabilitySuccess depends on individuals in chargeChoosing a Policy InstrumentPolicy instrument – a variable that responds to the central bank’s tools and indicates the stance (easy or tight) of monetary policy.Two basic types- Reserve aggregates- Short-term interest ratesIntermediate target – stands between the policy instrument and the goal.Examples- Monetary aggregates- Long-term interest ratesHow is setting monetary policy like the sport of bowling or curling?Central bank must choose either to maintain aggregates or interest rates; cannot maintain both variables in a dynamic economyWhen targeting on nonborrowed reservesinterest rates will fluctuateDevelop graph here.When targeting on interest ratesnonborrowed reserves will fluctuateDevelop graph here.Criteria for choosing a policy instruments and intermediate targets1. Observable and measurable2. Controllable by the central bank3. Predictable effect on goalsPolicy instruments and intermediate targets must match, i.e. aggregates go withaggregates and interest rates go with interest rates.Taylor RuleMethod for setting the target nominal federal funds rate when concerned about both inflation and employment (economic growth)Federal funds rate target =inflation + equil. real fed. funds rate + ½ inflation gap + ½ output gapInflation = current inflation rateEquil. Real fed. Funds rate = the real fed. Funds rate that is consistent with full employment in the long runInflation gap = actual inflation minus target inflationOutput gap = actual real GDP minus potential GDP (GDP at full
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