Conducting Monetary Policy: Goals and Targets
Originally, the Fed was set established to serve as a lender of last resort to commercial banks
(after a series of bank panics in the U.S.), i.e. operating the discount window. Since then the Fed
has been given two more monetary tools to control the money supply: open market operation and
reserve requirements.
The Fed’s monetary tools are used to control the level of money supply (or interest rate).
However, what are some of the objectives the Fed is trying to achieve? Since its original
inception, the Fed has been given the responsibility to help achieve the following goals with its
monetary tools.
(1) High employment
Two acts have been passed (the Employment Act of 1946 and the Full Employment and
Balanced Growth Act of 1978) which committed the U.S. government in achieving high
employment with stable prices.
Rather than understanding why it is important to have high unemployment, it is easier to
understand why it is important not to have high unemployment. High unemployment is usually
associated with human misery and idle resources.
Should it be the Fed’s goal to achieve zero unemployment? It is not necessarily favorable to an
economy to have no unemployment at all. Frictional unemployment (i.e. individuals that are
unemployed during a career change, life style change, etc. ) is actually beneficial. As a result, it
is more important for the Fed to target the natural rate of employment, i.e. the level of
employment where the demand of labor equals the supply of labor. However, estimating the
natural rate of employment (or unemployment) is very difficult.
(2) Economic growth
Economic growth and the level of employment go hand in hand. High economic growth usually
leads to high level of employment. However, economic growth and employment can be
Chapter 12-1
stimulated with different policies. Economic growth can be stimulated by providing companies
incentive to invest in new projects. This can be done through low interest and/or tax incentives.
(3) Price stability
Price stability is very crucial in keeping an economy function properly. Fluctuating prices make
decision making very difficult for businesses and owners. In addition, keeping prices stable also
means keeping the rate of inflation stable. If you remember, rising inflation means that
purchasing power will be eroded. The German Central Bank has adopted a very strict antiinflation monetary policy.
(4) Interest rate stability
Interest rate stability is desirable because it makes borrowing and lending less uncertain for
individuals and businesses. As interest rate becomes more volatile, individuals and businesses
will be less willing to borrow or lend.
(5) Stability of the financial markets
The degree of development of a country is usually measured by the degree of development of its
financial market. A highly sophisticated financial market eases the exchange of resources (or
funds) from lenders to borrowers. An unstable financial market will slow down the transfer of
such funds, which in turn will lead to slower economic growth.
(6) Stability in the foreign exchange market
The prosperity of a country depends heavily on its foreign trades and investments with other
countries. Trading allows a country to specialize in certain products and services (which will
lead to a higher level of output), and investments will attract funds from other countries.
However, the flow of trades and investments depends heavily on the stability of the foreign
exchange market. A volatile foreign exchange market will usually lead to a drop in foreign trades
and investments.
The goals listed above can all be achieved in the long-run, but there might be some conflict in the
short-run. For example, the economy is growing which means that businesses are investing more
in capitals and unemployment is falling. However, the increase in economic activity might raise
Chapter 12-2
the level of inflation if insufficient goods and services are produced to meet the demand, and the
level of interest rate will start rising.
Monetary Targets of the Fed
The objective of the Fed is to achieve the goals listed above with its monetary tools. However,
the Fed does not target those goals directly, because it usually take a while (i.e. lag) to see the
impact of its policy. If the policy is not on target, it will be too late for the Fed to go back to
change its policy. As a result, the Fed aims to influence a set of variables (known as
intermediate targets) which have direct impacts on the Fed’s desired goals. For example, if the
Fed wants to slow the economic activity (to control the economy’s inflation), it can target the
monetary aggregates (i.e. M1, M2 or M3) or the interest rates (short-term or long-term). In this
scenario, the economic activity and inflation rates are the Fed’s monetary goals, and the
monetary aggregates and interest rates are its intermediate targets.
Once the Fed has identify its intermediate targets, it influences them by targeting the operating
targets which it can better manipulate with its monetary tools. Some examples of the Fed’s
operating targets are reserve aggregates (reserves, non-borrowed reserves, monetary base, etc.)
and interest rates (federal funds rates and T-bill rates).
It is easier for the Fed to aim for the operating and intermediate targets than the goals because it
can see the results much faster and judge whether its policies are on the right track. If they are
not, the Fed will adjust them (using mostly OMO) to push them back on track.
How does the Fed go about implementing its monetary policy? First, the Fed needs to identify its
goals (e.g. an economic growth of 5%). Based on its research, the Fed knows that this goal can
be achieved with a 4% increase in M2, which can be accomplished with a 2% increase in
monetary base (i.e. OMO purchase). Since the effect of the OMO on the monetary base can be
determined very quickly, the Fed will know if its OMO is successful in stimulating a 2% increase
in monetary base. If the monetary base is not growing fast enough, it can stimulate it by
conducting more OMO purchase. And if the monetary base is growing too quickly, the Fed can
slow it down by conducting some OMO sale.
Chapter 12-3
Once the Fed has reached its operating target of having a 2% increase in monetary base, it will
need to determine if the M2 is growing at the target rate of 4%. If the M2 is not responding as
well as the Fed has hoped (e.g. a 3% increase) to a 2% increase in monetary base, the Fed will
boost the monetary base growth rate. On the other hand, if the M2 is responding too well to a 2%
increase in monetary base, the Fed will slow the growth rate of the monetary base.
(1) Choosing its Intermediate Targets
As we have mentioned earlier, the Fed can target the reserve aggregates and the interest
aggregates. However, the Fed can only target one of them and not both at the same time. In other
words, the Fed cannot control the money supply and the interest rate at the same time. The
reason for that is because the demand for money is out of the Fed’s control. Lets look at this
more carefully.
Suppose the demand for money is estimated to be M d and the Fed has targeted to control the
money supply so that it stays at M . Unfortunately, since the money demand is fluctuating
between M d and M d , the market interest rate fluctuates between i  and i  . As a result, when
the Fed wants control over the money supply, it loses control over the interest rate.
Interest
Ms
i
M"d
Md
M'd
Quantity
On the other hand, suppose the Fed plans to target the market interest rate at i . If the money
demand remains at M d , the Fed can achieved the desired market interest rate with money supply
M s . However, since the demand for money fluctuates between M d and M d , the Fed has to
constantly adjust the money supply to keep the interest rate maintain at i . As a result, when the
Fed wants control over the interest rate, it loses control over the money supply.
Chapter 12-4
Interest
M's
Ms
M "s
i
M"d
Md
M'd
Quantity
(2) Criteria for Choosing Intermediate Targets
We know that the Fed has to choose either the money supply or the interest rate as the
intermediate target. What criteria does the Fed use to pick its intermediate target? The Fed will
pick its target based on three criteria: (i) measurability, (ii) controllability, and (iii) predictable
impact on the goals.
Chapter 12-5