[Just one lecture this week. Happy Thanksgiving.]

* Today (Mishkin's Chapter 18):
I. Monetary policy in practice: The Fed's goals
II. Targets of monetary policy
 

I. MONETARY POLICY IN PRACTICE: THE FED'S GOALS

The Federal Reserve is most closely identified with efforts to keep inflation low, but it actually has six basic goals. They are:

(1) high employment
(2) economic growth
(3) price stability
(4) interest rate stability
(5) financial market stability
(6) stability of the foreign exchange rate

Let us review each of those goals, and what they mean to the Fed, one by one.

(1) high employment

The Employment Act of 1946 commits the Fed to "maximum sustainable employment at stable prices." The Humphrey-Hawkins Act of 1978, called the Full Employment and Balanced Growth Act, does much the same, and also requires the Fed Chairman to testify before Congress on a regular basis. The term "full employment" is really a misnomer, since there is always some unemployment in the economy, even at such peak times as WWII. Frictional unemployment occurs when people are merely searching for the right job, after quitting their old job or being out of the labor force for some time (say, as a full-time student or homemaker). In addition, some unemployment is structural or mismatch unemployment, resulting from a mismatch between what employers are looking for (in terms of skills or location) and what job seekers have to offer. High rates of unemployment in the inner cities are an example of structural unemployment. What economists call "full employment" really means the NAIRU (non-accelerating-inflation rate of unemployment) -- the lowest unemployment rate that is consistent with a stable rate of inflation. If the unemployment rate dips below the NAIRU, the inflation rate will rise and will keep on rising for as long as the unemployment rate stays below the NAIRU. If the unemployment rate is above the NAIRU, the inflation rate will fall and will continue to fall for as long as the unemployment is higher than the NAIRU -- that's why recessions and high unemployment are indispensable to an all-out war on inflation, such as the Fed conducted in the early 1980s. (Some economists, such as Mishkin, prefer to use the term "natural rate of unemployment," instead of NAIRU, but that term is truly an abomination, since it implies that structural unemployment -- which is typically involuntary -- is part of the natural order of things.)

The NAIRU is currently about 4%, or so we think -- nobody really knows for sure. The current [October 2000] unemployment rate is 3.9%, and there are no signs whatsoever of increasing inflation. For years economists believed the NAIRU was about 6% -- either they were wrong, or the NAIRU has fallen sharply in the last few years.

(2) economic growth

This goal would seem to be the same as high employment, since strong economic growth creates jobs and reduces unemployment. Okun's Law states that for every percentage-point increase in real GDP, relative to potential GDP, the unemployment rate falls by 0.4 percentage points. If real GDP and potential GDP grow at the same rate, however, the unemployment rate will not fall. Recall that potential GDP is the level of GDP that corresponds to the NAIRU -- potential GDP is the economy's highest "sustainable" level of GDP, in the sense of being consistent with a stable inflation rate. So the Fed, as an anti-inflation hawk, would favor increasing GDP up to the level of potential GDP, but no further. The ideal policy solution would be to find ways to increase the growth rate of potential GDP, by increasing the economy's capacity. Providing incentives for people to work and invest are ways to increase potential GDP. Incentives to save and invest are particularly important because investment in physical capital (plant and equipment) raises the economy's productive capacity. Investment in human capital -- i.e., education and skills training -- does the same. "Supply-side" economic policies hold that low marginal tax rates are the best way to get people to work and save more. Fed Chairman Alan Greenspan believes that a stable price level, by removing the economic inefficiencies inherent in inflation, would also promote a higher level of potential GDP.

(3) price stability

The U.S. economy does not seem to function well under high inflation, as we learned in the inflationary decade of the 1970s. Inflation is particularly costly for those living on fixed incomes or long-term fixed interest payments. Inflation also makes it difficult for people to make correct judgments about how relative prices have changed -- when people mistake absolute price changes for relative price changes (as would be the case if, say, a 3% rise in the cost of beans when the general inflation rate is also 3% led you to stop buying beans), they commit the error of "money illusion" and may make many bad decisions as a result.

(4) interest rate stability

Volatile interest rates can be extremely damaging to banks. If the current interest rate shoots up, banks that are holding mostly fixed-rate, long-term assets will see the resale value of those assets plummet and could face insolvency. Businesses that rely heavily on borrowing will see a sharp rise in their costs. If the current interest rate falls sharply, banks that are holding mostly variable-rate assets (like adjustable-rate mortgages) will see a sharp decline in their interest income and might also face insolvency. For consumers, volatile interest rates increase the riskiness of decisions about whether or when to buy a house or a car or any other durable good that necessitates a series of installment payments.

(5) financial market stability

In a financial crisis, credit intermediation, the process by which financial institutions channel funds from savings to productive investment, tends to break down. People tend to hoard currency (C/D rises) and banks tend to hoard reserves (ER/D rises), thereby shrinking the money multiplier, the money supply and the volume of productive loans and business investment. Anything the Fed can do to promote a stable financial system -- serving as a lender of last resort, keeping interest rates stable -- will generally be good for the economy.

(6) stability of the foreign exchange rate

First, let's review a couple definitions:
* The dollar APPRECIATES (or RISES) when it becomes more expensive in terms of foreign currency.
--> American exports become more expensive abroad; foreign imports become cheaper here
---- good for American consumers and American tourists abroad
---- helps keep inflation low, because the imports we buy are now cheaper
---- bad for American exporters and American producers who compete with imports.
* The dollar DEPRECIATES (or FALLS) when it becomes cheaper in terms of foreign currency.
--> American exports become cheaper abroad; foreign imports become more expensive here
---- bad for American consumers and American tourists abroad
---- tends to increase inflation, because the imports we buy are now pricier
---- good for American exporters and American producers who compete with imports

As trade has become increasingly important in relation to the U.S. economy, avoiding sharp swings in the foreign-exchange value of the dollar is an increasingly important task of Fed policy. Indeed, in places like Europe where trade is a much larger percentage of GDP, maintaining exchange-rate stability is one of the most important goals of those countries' central banks (which is one reason why 11 European countries have just adopted a common currency, the Euro). Either a major appreciation or a major depreciation of the dollar can be problematic:
-- A severe depreciation of the dollar helps American exporters but hurts American consumers (and American firms that purchase materials and parts from abroad) by raising import prices; the increase in prices is also inflationary, by definition.
-- A major appreciation of the dollar helps American consumers but hurts our trade balance by making foreign imports cheaper and U.S. exports more expensive.

The Fed's six goals, then, are closely related but often in conflict. For example, a strong dollar (i.e., a high foreign exchange price for the dollar) helps keep inflation at bay but hurts American exports, GDP, and jobs. The Fed can help bring down the dollar's exchange rate by reducing interest rates, which reduces international demand for dollars and thereby causes the dollar to depreciate, but too large a reduction in interest rates would be inflationary and would add to the volatility of interest rates. With so many different goals, the Fed's optimal solution is something of a compromise solution. No single goal is so important as to override all the others.
 

II. TARGETS OF MONETARY POLICY

You know the Fed's tools (OMO, discount loans, RRR). You know the Fed's goals. Getting from tools to goals is where the targets of monetary policy come in.
 

TOOLS -->	OPERATING_TARGETS-->	INTERMEDIATE TARGETS -->	GOALS
the Fed's decision variables	things the Fed affects fairly directly	things the Fed affects more indirectly	(6 in all; see above)
(OMO, discount loans, changing RRR)	(reserves, MB, federal funds rate)	(M1, M2, M3, prime interest rate, long-term interest rates)

The big question for Fed policy-makers: Which target should the Fed use? Interest rates or a monetary aggregate?

Why this matters: Recall those diagrams of the money market that we saw when we did the liquidity preference framework. If you target (or "peg") the interest rate, the money supply may fluctuate wildly, perhaps causing inflation. If you target the money supply, interest rates may fluctuate wildly. The reason in both cases is that money demand -- the public's demand for currency and checking deposits -- can be highly variable.

The Fed's usual target has been the interest rate, instead of the money supply. At an extreme, in WWII the Fed pegged the interest rate, holding it absolutely constant despite rapidly rising GDP growth. (That policy would have been inflationary if not for wartime wage and price controls.) The Fed did the same in the 1960's, while the government ran big deficits, and the result was rising inflation. The only time the Fed has exclusively targeted a monetary aggregate was at the beginning of Paul Volcker's term (1979-82), when the Fed's War on Inflation revolved around drastically slowing the growth rate ofnon-borrowed reserves (= bank reserves - discount loans). Interest rates soared, and fluctuated greatly. (Mishkin speculates that the Fed's stated emphasis on a monetary aggregate may have simply been a shrewd political strategy, since a deliberate and massive increase in interest rates would have been extremely unpopular. The Fed's real dedication was to stamping out inflation, not to slavishly obeying monetary targets.)