Chapter 10 Conduct of Monetary Policy: Tools, Goals,
Strategy,
and Tactics
247
Quantity of
Reserves, R
Federal Funds
Rate Target, i
ff
*
NBR
⬘
NBR
⬙
NBR*
Federal
Funds Rate
R
s
R
d*
R
d
⬘
i
ff
*
i
er
i
d
R
d
⬙
F I G U R E 1 0 . 7
Result of Targeting on the Federal Funds Rate
Targeting on the interest rate
will lead to fluctuation in nonborrowed reserves because of
fluctuations in the demand for reserves between
and
.
R
d
–
R
d
¿
i
*
ff
The conclusion from the supply-and-demand analysis is that interest-rate and
reserve (monetary) aggregate targets are incompatible. A central bank can hit one
or the other, but not both. Because a choice between them has to be made, we need
to examine what criteria should be used to select a policy instrument.
Quantity of
Reserves, R
NBR*
i
ff
⬙
Federal
Funds Rate
R
s
R
d*
R
d
⬘
i
ff
*
i
er
i
d
i
ff
⬘
R
d
⬙
F I G U R E 1 0 . 6
Result of Targeting on Nonborrowed Reserves
Targeting on nonborrowed reserves of
NBR* will lead to fluctuations in the federal funds
rate between
and
because of fluctuations in the demand for reserves between
and
.
R
d
–
R
d
¿
i
–
ff
i
¿
ff
248
Part 4 Central Banking and the Conduct of Monetary Policy
Criteria for Choosing the Policy Instrument
Three criteria apply when choosing a policy instrument: The instrument must be
observable and measurable, it must be controllable by the central bank, and it must
have a predictable effect on the goals.
Observability and Measurability
Quick observability and accurate measurement
of a policy instrument is necessary, because it will be useful only if it signals the
policy stance rapidly. Reserve aggregates like nonborrowed reserves are straight-
forward to measure, but there is still some lag in reporting of reserve aggregates (a
delay of two weeks). Short-term interest rates like the federal funds rate, by contrast,
not only are easy to measure, but also are observable immediately. Thus, it seems that
interest rates are more observable and measurable than are reserves and, there-
fore, are a better policy instrument.
However, as we learned in Chapter 3, the interest rate that is easiest to measure
and observe is the nominal interest rate. It is typically a poor measure of the real cost
of borrowing, which indicates with more certainty what will happen to the real GDP.
This real cost of borrowing is more accurately measured by the real interest rate—
that is, the nominal interest rate adjusted for expected inflation (
).
Unfortunately, real interest rates are extremely difficult to measure, because we do
not have a direct way to measure expected inflation. Given that both interest rates
and aggregates have observability and measurability problems, it is not clear whether
one should be preferred to the other as a policy instrument.
Controllability
A central bank must be able to exercise effective control over a
variable if it is to function as a useful policy instrument. If the central bank cannot
control the policy instrument, knowing that it is off track does little good, because
the central bank has no way of getting it back on track.
Because of shifts in and out of currency, even reserve aggregates such as non-
borrowed reserves are not completely controllable. Conversely, the Fed can control
short-term interest rates such as the federal funds rate very tightly. It might appear,
therefore, that short-term interest rates would dominate reserve aggregates on the
controllability criterion. However, a central bank cannot set short-term real inter-
est rates because it does not have control over expectations of inflation. Once again,
a clear-cut case cannot be made that short-term interest rates are preferable to
reserve aggregates as a policy instrument, or vice versa.
Predictable Effect on Goals
The most important characteristic of a policy instru-
ment is that it must have a predictable effect on a goal. If a central bank can accu-
rately and quickly measure the price of tea in China and can completely control its
price, what good will that do? The central bank cannot use the price of tea in China
to affect unemployment or the price level in its country. Because the ability to affect
goals is so critical to the usefulness of any policy instrument, the tightness of the
link from reserve or monetary aggregates to goals (output, employment, and infla-
tion) or, alternatively, from interest rates to these goals, is a matter of much debate.
In recent years, most central banks have concluded that the link between interest
rates and goals such as inflation is tighter than the link between aggregates and infla-
tion. For this reason, central banks throughout the world now generally use short-
term interest rates as their policy instrument.
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r
⫽ i ⫺ p
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