are incompatible, the CB cannot target reserves and interest rates simultaneously.
Why is that? Although the CB expects the demand curve for reserves to be at R
d*
, it fluctuates
between R
d’
and R
d’’
because of movements in deposits (hence required reserves) and changes in
banks’ desire to hold excess reserves. If the CB has a non-borrowed reserves target of NBR*, it
expects that the short-term interest rate will be i*. However, as the first figure indicates the short-
term interest rate will fluctuate between i’and i’’. To maintain the interest rate at i*,
the CB would
have to move the NBR along and let it fluctuate between NBR’ and NBR’’
. This is the reason the
targets are incompatible.
Three criteria have to be fulfilled for choosing the policy instrument:
1.
Observability and measurability – quickly observable and measurable
2.
Controllability – instrument should be fully controlled with tool
3.
Predictable effect on goals – there must be a stable and predictable relationship with the
goal,
a correlation
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Nowadays most CBs target short-term interest rates as policy instrument. But how should this
rate be set?
Taylor rule
i = equilibrium real i + inflation rate + ½(inflation gap) + ½(output gap)
i = r* + π + ½(π – π*) + ½(Y – Y*)
(where π* and Y* are the objective levels respectively, output gap = % deviation of real GDP from
its potential level)
The Taylor principle is thus that if the inflation rate increases by 1%, the CB should raise i by
1.5%. Stabilizing the real output is an important concern and the output gap is an indicator of
future inflation.
When looking at the empirical comparison between Taylor and the actual EONIA in the past
years, two things deserve attention:
1)
Taylor is structurally higher than EONIA and
2)
they both
consistently move in the same direction.
Almost the same applies for the UK and US:
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