The central bank's problem is that it wishes to achieve certain goals, such as price stability with high employment, but it does not directly influence the goals. It has a set of tools to employ (open market operations, changes in the discount rate, and changes in reserve requirements) that can affect the goals indirectly after a period of time (typically more than a year). If the central bank waits to see what the price level and employment will be one year later, it will be too late to make any corrections to its policy—mistakes will be irreversible.
All central banks consequently pursue a different strategy for conducting monetary policy by aiming at variables that lie between its tools and the achievement of its goals. The strategy is as follows: After deciding on its goals for employment and the price level, the central bank chooses a set of variables to aim for, called intermediate targets, such as the monetary aggregates (M1, M2, or M3) or interest rates (short- or
Conflict Among Goals long-term), which have a direct effect on employment and the price level. However, even these intermediate targets are not directly affected by the central bank's policy tools. Therefore, it chooses another set of variables to aim for, called operating targets, or alternatively instrument targets, such as reserve aggregates (reserves, non-borrowed reserves, monetary base, or nonborrowed base) or interest rates (federal funds rate or Treasury bill rate), which are more responsive to its policy tools. (Recall that nonborrowed reserves are total reserves minus borrowed reserves, which are the amount of discount loans; the nonborrowed base is the monetary base minus borrowed reserves; and the federal funds rate is the interest rate on funds loaned overnight between banks.)2
The central bank pursues this strategy because it is easier to hit a goal by aiming at targets than by aiming at the goal directly. Specifically, by using intermediate and operating targets, it can more quickly judge whether its policies are on the right track, rather than waiting until it sees the final outcome of its policies on employment and the price level.3 By analogy, NASA employs the strategy of using targets when it is trying to send a spaceship to the moon. It will check to see whether the spaceship is positioned correctly as it leaves the atmosphere (we can think of this as NASA's "operating target"). If the spaceship is off course at this stage, NASA engineers will adjust its thrust (a policy tool) to get it back on target. NASA may check the position of the spaceship again when it is halfway to the moon (NASA's "intermediate target") and can make further midcourse corrections if necessary.
The central bank's strategy works in a similar way. Suppose that the central bank's employment and price-level goals are consistent with a nominal GDP growth rate of 5%. If the central bank feels that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M2 (its intermediate target), which will in turn be achieved by a growth rate of 32% for the monetary base (its operating target), it will carry out open market operations (its tool) to achieve the 32% growth in the monetary base. After implementing this policy, the central bank may find that the monetary base is growing too slowly, say at a 2% rate; then it can correct this too slow growth by increasing the amount of its open market purchases. Somewhat later, the central bank will begin to see how its policy is affecting the growth rate of the money supply. If M2 is growing too fast, say at a 7% rate, the central bank may decide to reduce its open market purchases or make open market sales to reduce the M2 growth rate.
One way of thinking about this strategy (illustrated in Figure 1) is that the central bank is using its operating and intermediate targets to direct monetary policy (the space shuttle) toward the achievement of its goals. After the initial setting of the policy tools (the liftoff), an operating target such as the monetary base, which the central bank can control fairly directly, is used to reset the tools so that monetary policy is channeled toward achieving the intermediate target of a certain rate of money supply growth. Midcourse corrections in the policy tools can be made again when the central bank
2There is some ambiguity as to whether to call a particular variable an operating target or an intermediate target. The monetary base and the Treasury bill rate are often viewed as possible intermediate targets, even though they may function as operating targets as well. In addition, if the Fed wants to pursue a goal of interest-rate stability, an interest rate can be both a goal and a target.
3This reasoning for the use of monetary targets has come under attack, because information on employment and the price level can be useful in evaluating policy. See Benjamin M. Friedman, "The Inefficiency of Short-Run Monetary Targets for Monetary Policy," Brookings Papers on Economic Activity 2 (1977): 292-346.
Tools of the Central Bank
Open market operations Discount policy Reserve requirements
FIGURE 1 Central Bank Strategy
Operating (Instrument) Targets Intermediate Targets
Reserve aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base) Interest rates (short-term such as federal funds rate)
Monetary aggregates (M1, M2, M3) Interest rates (short-and long-term)
High employment, price stability, financial market stability, and so on.
FIGURE 1 Central Bank Strategy sees what is happening to its intermediate target, thus directing monetary policy so that it will achieve its goals of high employment and price stability (the space shuttle launches the satellite in the appropriate orbit).
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