im21 - Chapter 21 The Conduct of Monetary Policy Overview...

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Chapter 21 The Conduct of Monetary Policy Overview This chapter highlights the central paradox facing the Fed: It has goals for employment, output, and the price level, but it has no ability to affect these goals directly. The chapter provides a thorough discussion of the ways in which the Fed uses the tools available to it in an attempt to achieve its goals. The need for intermediate and operating targets is discussed. Intermediate targets are objectives for financial variables, such as interest rates and monetary aggregates, that the Fed believes will directly help it achieve its goals. The Fed can control its intermediate targets only indirectly because of the impact on these variables of private sector decisions. Therefore, the Fed uses a second set of targets—operating targets—which are variables the Fed can control directly and which are closely related to its intermediate targets. The author argues that intermediate targets are selected on the basis of whether they meet the criteria of measurability, controllability, and predictability. However, using these criteria to choose between a monetary aggregate and an interest rate as an intermediate target turns out to be difficult. In principle, if the real side of the economy is stable, interest rate targets would be preferred and, if the financial side of the economy is stable, money supply targets would be preferred. In practice, the Fed encounters instability on both sides of the economy. Once the Fed has selected an intermediate target, it must decide on the operating target that will best influence the intermediate target. If the Fed chooses a monetary aggregate as an intermediate target, it will choose a reserve aggregate as an operating target. If the Fed chooses an interest rate as an intermediate target, it will choose the federal funds rate as an operating target. The chapter concludes by analyzing monetary theory in practice through a discussion of Fed policy since World War II. Recent developments considered include the Taylor rule and inflation targeting. The Taylor rule states that the current fed funds rate should be the sum of the inflation rate, the equilibrium real fed funds rate, and terms representing the inflation gap—the difference between current inflation and a target rate—and the output gap—the percentage difference of real GDP from its estimated full-employment level. The pros and cons of inflation targeting are presented and evaluated. Outline I. Goals of Monetary Policy A) The Fed has set six monetary policy goals that are intended to promote a well-functioning economy: price stability, high employment, economic growth, financial market and institution stability, interest rate stability, and foreign-exchange market stability. B)
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This note was uploaded on 09/11/2011 for the course ECON 304 taught by Professor Sanchez during the Fall '11 term at NMSU.

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im21 - Chapter 21 The Conduct of Monetary Policy Overview...

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