,Chapter 18,Conduct of Monetary Policy: Goals and Targets, 2005 Pearson Education Canada Inc.,Goals of Monetary Policy,Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict,2, 2005 Pearson Education Canada Inc.,High Employment,High employment is a worthy goal for two reasons: 1. The alternative situation, high unemployment, causes much human misery, with people suffering financial distress, loss of personal self-respect, and in crime. 2. When u is high, the economy has not only idle workers but also idle resources, resulting in a lower GDP. But how low should u be? Because frictional unemployment (which involves searches by workers and firms to find suitable matchups) is desirable, and because policy can do little about structural unemployment (due to a mismatch between job requirements and the skills of workers), the goal of high employment should seek not u = 0 but u 0 consistent with full employment (at which the demand for labor equals the supply of labor). This level of u is called the natural rate of unemployment.,3, 2005 Pearson Education Canada Inc.,Economic Growth,The goal of steady economic growth is closely related to the goal of low u because businesses are more likely to invest in physical capital to productivity and growth when u is low. If u is high and factories are idle, it does not pay for firms to invest in additional physical capital. Hence, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. In fact, this is the stated purpose of so-called supply-side economic policies, which provide tax incentives for firms to invest more and for people to save more.,4, 2005 Pearson Education Canada Inc.,Price Stability,In recent years policymakers have become increasingly aware of the social and economic costs of inflation and more concerned with a stable P as a goal of economic policy. In fact, P stability is viewed as the most important goal for monetary policy because inflation creates uncertainty that may hamper growth inflation makes it hard to plan for the future inflation may strain a countrys social fabric (by creating conflicts between different groups) extreme inflation, known as hyperinflation, leads to slower growth as for example in Argentina, Brazil, and Russia in the recent past.,5, 2005 Pearson Education Canada Inc.,Interest-Rate Stability,Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty and make it harder (for both firms and households) to plan for the future. A central bank may also want to reduce upward movements in interest rates because such movements generate hostility toward central banks and lead to demands that their independence and power should be reduced (see Chapter 14).,6, 2005 Pearson Education Canada Inc.,Stability of Financial Markets,Financial crises can interfere with the ability of financial markets to channel funds from surplus spending units to deficit spending units, thereby leading to a sharp contraction in economic activity. The promotion of a more stable financial system in which financial crises are avoided is thus an important goal for a central bank. The stability of financial markets is also fostered by i stability because fluctuations in i create uncertainty for financial firms, affecting both their profits as well as their net worth.,7, 2005 Pearson Education Canada Inc.,Stability in Foreign Exchange Markets,The value of the $ has become a major consideration for the Bank of Canada. An in E makes Canadian industries less competitive with those abroad and a in E stimulates inflation in Canada. Also preventing large changes in E makes it easier for firms and people involved in international trade to plan ahead. Stabilizing extreme movements in E in FX markets is thus viewed as a worthy goal of monetary policy. In fact, in countries which are even more dependent on foreign trade, stability in FX markets takes on even greater importance.,8, 2005 Pearson Education Canada Inc.,Conflict Among Goals,Many of the goals mentioned are consistent with each other as, for example, high employment with economic growth, and i stability with financial market stability. However, P stability is in conflict with i stability and low u in the short run (but probably not in the long run). For example, when the economy is expanding and u both and i may start to . If the Bank tries to prevent an in i, this may cause the economy to overheat and stimulate . But if the Bank i to prevent , in the short run u may . The conflict among goals may thus present central banks with some hard choices!,9, 2005 Pearson Education Canada Inc.,Central Bank Strategy,10, 2005 Pearson Education Canada Inc.,Use of (Operating and Intermediate) Targets,Suppose that the Bank wants to achieve a 5% rate of