Monetary Economics II

Lecture 9:
Monetary Policy and Choice of Instrument
Undergraduate Program
Faculty of Economics and Business
Universitas Gadjah Mada

2022/23
Monetary Policy and Choice of Instrument

Choice of Monetary Instruments

The Poole’s Analysis

Monetary Policy Rules

Background

▪ The actual implementation of monetary policy involves a variety of

rules, traditions, and practices, and these collectively are called
operating procedures.
▪ The objective in examining monetary policy operating procedures
is to understand what instruments are actually under the control of
the monetary authority, also the factors that determine the optimal
instrument choice.
▪ In this meeting, we want to answer, “What is the best policy
instrument of a central bank, given the uncertainties that are
inevitable part of policymaking?”
The Conduct of Monetary Policy
Central banks are normally mandated to achieve certain goals such as
CENTRAL BANK price stability, high growth, low unemployment etc. But central banks do
not directly control these variables.

MONETARY
POLICY
GOALS

▪ Price Stability
▪ Economic Growth
▪ High Employment
▪ Stability of Financial
Markets
▪ Stability in Foreign
Exchange Markets
The Conduct of Monetary Policy
Central banks have set of tools which they can use to achieve these
CENTRAL BANK objectives. The problem of central bank is compounded by the fact that
their tools do not directly affect these goals.

MONETARY
TOOLS OF THE GOALS
POLICY
CENTRAL BANK

CONVENTIONAL
▪ Open market operations
▪ Price Stability
▪ Reserve requirement ▪ Economic Growth
▪ Discount policy ▪ High Employment
▪ Stability of Financial
NON-CONVENTIONAL Markets
▪ Interest on Reserve ▪ Stability in Foreign
Exchange Markets
▪ Large-Scale Asset
Purchases
▪ Forward Guidance
The Conduct of Monetary Policy
Central bank use policy Instruments and targets, such as money supply
CENTRAL BANK and interest rates, which have direct and predictable impact on goal
variables and can be quickly and more easily observed.

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS

CONVENTIONAL
▪ Open market operations ▪ Reserve Aggregates ▪ Price Stability
▪ Reserve requirement (reserves, non-borrowed ▪ Monetary Aggregates ▪ Economic Growth
reserves, monetary base, (M1, M2)
▪ Discount policy ▪ High Employment
nonborrowed base)
▪ Stability of Financial
NON-CONVENTIONAL Markets
▪ Short-term and long-
▪ Interest on Reserve ▪ Short-term Interest Rates term interest rates ▪ Stability in Foreign
(such as fed fund rate, Exchange Markets
▪ Large-Scale Asset
Purchases BI7DRR)

▪ Forward Guidance
Time Lags of Monetary Policy

CENTRAL BANK

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS

TIME LAGS

The tools of monetary policy affect goal variables with lags and
these lags may be uncertain.
Monetary Policy Instruments
Central bank controls policy Instruments in order to affect the
CENTRAL BANK intermediate targets. Which policy instrument is better? Money
supply or short-term interest rates?

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS

▪ Reserve Aggregates
(reserves, non-borrowed ▪ Monetary Aggregates
reserves, monetary base, (M1, M2)
nonborrowed base)

▪ Short-term and long-

▪ Short-term Interest Rates term interest rates
(such as fed fund rate,
BI7DRR)
Monetary Policy Instruments

These two sets of policy instruments are not independent of

each other.
▪ If the central bank chooses monetary aggregate, then it will
have to leave interest rate to be determined by the market
forces (through money market).
▪ If it chooses interest rate, then monetary aggregate is
determined by the market forces.
Monetary Policy Instruments

Targeting on the money supply at M* will lead to fluctuations Targeting on the interest rate at M* will lead to fluctuations in
in the interest rate between 𝑖 ′ and 𝑖 ′′ because of fluctuations the money supply between 𝑀′ and 𝑀′′ because of fluctuations
in the money demand curve between 𝑀𝑑′ and 𝑀𝑑′′ . in the money demand curve between 𝑀𝑑′ and 𝑀𝑑′′ .
Monetary Policy and Choice of Instrument

Choice of Monetary Instruments

The Poole’s Analysis

Monetary Policy Rules

The Instrument Choice Problem

▪ If the monetary policy authority can choose between

employing an interest rate or a monetary aggregate as its
policy instrument, which should it choose?
▪ The classic analysis of this question is based on Poole
(1970).
▪ He showed how the stochastic structure of the economy—the
nature and different types of disturbances—would determine
the optimal choice of instrument.
Deterministic IS-LM Model

Consider a fully employed economy with a simple IS-LM model.

The IS function:
𝑦 ∗ = −𝛼𝑟 ∗
Where 𝑦 is real output (GDP), 𝑟 is real interest rate.
Deterministic IS-LM Model

Consider a fully employed economy with a simple IS-LM model.

The IS function:
Because central bank policy rate is nominal term, we redefine the IS
function:
𝑦 ∗ = −𝛼𝑟 ∗
𝑦 ∗ = −𝛼 𝑖 ∗ − 𝜋 𝐸
Where 𝑖 is nominal interest rate, and 𝜋 𝐸 is expected inflation.
Deterministic IS-LM Model

Consider a fully employed economy with a simple IS-LM model.

The LM function:
𝑚∗ − 𝑝∗ = 𝑦 ∗ − 𝛽𝑖 ∗

Where 𝑚 is money supply, 𝑝 is price.

Deterministic IS-LM Model

▪ Here price level prices is normalized and is assumed to be

constant and thus analysis pertains to short-term (or choices
of instruments and indicators).
𝑃 = 1 and 𝑙𝑛𝑃 ≡ 𝑝 = 0

▪ Expected inflation is also kept as constant.

𝜋𝐸 = 0
Deterministic IS-LM Model

Consider a fully employed economy with a simple IS-LM model.

The IS function: The LM function:

𝑦 ∗ = −𝛼 𝑖 ∗ − 𝜋 𝐸 𝑚∗ − 𝑝∗ = 𝑦 ∗ − 𝛽𝑖 ∗
𝑦∗ = −𝛼 𝑖∗ 𝑚∗ = 𝑦 ∗ − 𝛽𝑖 ∗
Stochastic IS-LM model

If there were stochastic shocks occur to both the goods market and the
money market, output would be random.

The IS function: The LM function:

𝑦𝑡 = −𝛼 𝑖𝑡 + 𝑧𝑡 𝑚𝑡 = 𝑦𝑡 − 𝛽𝑖𝑡 + 𝑣𝑡

Where 𝑧𝑡 is positive shocks on the IS.

Where 𝑣𝑡 is positive shocks on the LM.
Shocks 𝑧𝑡 have mean zero,
Shocks 𝑣𝑡 have mean zero, independent
independent shocks with variances 𝜎𝑧2
shocks with variances 𝜎𝑣2
Central Bank’s Objective

We assume that policy makers want to stabilize actual output 𝑦𝑡 ,

around full employment output 𝑦 ∗ . This assumption is reflected in
the quadratic loss function:

L = 𝐸 𝑦𝑡 − 𝑦 ∗ 2

The objective of the central bank is to minimize the variance of

output deviations from full employment output, set to zero:

min 𝐸 𝑦𝑡 2
Central Bank’s Objective

Simple objective of policy: Minimize output variance

min 𝐸 𝑦𝑡 2

▪ The problem of the policy maker is to choose between these

two instruments money supply (m) or interest rate (i)
▪ Policy of under operating target is conducted before shocks 𝑧𝑡
and 𝑣𝑡 hit.
Model Timing

The timing is as follows: the central bank (CB) sets either money
supply (m) or interest rate (i) at the start of the period, then the
stochastic shocks 𝑧𝑡 and 𝑣𝑡 occur, which determine output 𝑦𝑡 .

TIMING OF EVENTS

CB sets interest rate or Shocks (𝒛𝒕 and 𝒗𝒕 )

monetary aggregate hit
Money Supply as Instrument
When money supply is instrument, 𝑦𝑡 is Set 𝑚𝑡 such that 𝐸(𝑦𝑡 ) = 0 (i.e. we set
solved in terms of 𝑚𝑡 :
𝑚𝑡 constant (𝑚𝑡 = 0) and let interest rates
𝑦𝑡 = −𝛼 𝑖𝑡 + 𝑧𝑡 fluctuate)
𝑚𝑡 = 𝑦𝑡 − 𝛽𝑖𝑡 + 𝑣𝑡 −𝛼𝑣𝑡 + 𝛽𝑧𝑡
𝑦𝑡 =
𝛼+𝛽
Therefore, we define 𝑖𝑡 and plug it into 𝑦𝑡 The value of the objective function under a
money supply procedure:
𝑦𝑡 − 𝑚𝑡 + 𝑣𝑡
𝑦𝑡 = −𝛼 + 𝑧𝑡
𝛽 2
2
−𝛼𝑣𝑡 + 𝛽𝑧𝑡
𝐸𝑚 𝑦𝑡 =
𝛼 𝑚𝑡 − 𝑣𝑡 𝛼+𝛽
𝑦𝑡 + 𝑦𝑡 = 𝛼 + 𝑧𝑡
𝛽 𝛽 The output variance:
𝛼𝑚𝑡 − 𝛼𝑣𝑡 + 𝛽𝑧𝑡
𝑦𝑡 = 𝟐
𝜶𝟐 𝝈𝟐𝒗 + 𝜷𝟐 𝝈𝟐𝒛
𝛼+𝛽 𝑬 𝒎 𝒚𝒕 =
𝜶+𝜷 𝟐
Interest Rate as Instrument
When interest rate is the policy The value of the objective function
instrument, the central bank under interest rate procedure:
optimally chooses it and allows 2 2
𝐸𝑖 𝑦𝑡 = 𝑧𝑡
money supply to adjust:
𝑦𝑡 = −𝛼 𝑖𝑡 + 𝑧𝑡
The output variance:
𝟐
𝑬𝒊 𝒚𝒕 = 𝝈𝟐𝒛
Set 𝑖𝑡 such that 𝐸(𝑦𝑡 ) = 0 (i.e. we
set 𝑖𝑡 constant (𝑖𝑡 = 0) and let
money supply fluctuate)
𝑦𝑡 = 𝑧𝑡
Comparison

In order to find out optimal policy rule, we have to compare

the value of the objective function under a money supply
procedure and interest rate procedure.
𝟐 𝟐
𝑬𝒎 𝒚𝒕 = 𝑬𝒊 𝒚𝒕
𝛼 2 𝜎𝑣2 + 𝛽2 𝜎𝑧2 2
2
= 𝜎𝑧
𝛼+𝛽
Case 1: Aggregate Demand Shocks

If only aggregate demand shocks hit (i.e., 𝑣 = 0), a money

supply rule leads to a smaller variance for output:
𝛼 2 𝜎𝑣2 + 𝛽2 𝜎𝑧2 2
= 𝜎𝑧
𝛼+𝛽 2
𝛼 2 . (0) + 𝛽2 𝜎𝑧2 2
= 𝜎𝑧
𝛼+𝛽 2
𝛽2 𝜎𝑧2
2
< 𝜎𝑧2
𝛼+𝛽
Case 1: Aggregate Demand Shocks
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 𝑡𝑎𝑟𝑔𝑒𝑡

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡

𝑖∗

𝑰𝑺∗∗ 𝑰𝑺∗∗

𝑰𝑺 𝑰𝑺
𝑰𝑺∗ 𝑰𝑺∗

𝑌𝑖∗ 𝑌 𝑌𝑖∗∗ 𝑂𝑢𝑡𝑝𝑢𝑡 𝑌𝑚∗ 𝑌 𝑌𝑚∗∗ 𝑂𝑢𝑡𝑝𝑢𝑡

When 𝑰𝑺 curve is unstable (fluctuates from 𝑰𝑺∗ to 𝑰𝑺∗∗ ’), When 𝑰𝑺 curve is unstable (fluctuates from 𝑰𝑺∗ to 𝑰𝑺∗∗ ’),
interest rate target leads output to fluctuate from 𝑌𝑖∗ to 𝑌𝑖∗∗ money supply target leads output to fluctuate from 𝑌𝑚∗ to 𝑌𝑚∗∗
Case 1: Aggregate Demand Shocks
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 𝑡𝑎𝑟𝑔𝑒𝑡

▪ When IS curve is unstable, output

fluctuation is less when money supply
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡 is the policy target.
𝑖∗
▪ In other words, if shocks in goods
market is larger than shocks in money
market, central bank should choose
𝑰𝑺∗∗ money targeting policy.

𝑰𝑺 ▪ A money targeting policy leads to

𝑰𝑺∗ smaller variance in output.

𝑌𝑖∗ 𝑌𝑚∗ 𝑌 𝑌𝑚∗∗ 𝑌𝑖∗∗ 𝑂𝑢𝑡𝑝𝑢𝑡

Case 2: Money Market Shocks

If only money market shocks hit (i.e., 𝑧 = 0), an interest rate

rule leads to a smaller variance for output:
𝛼 2 𝜎𝑣2 + 𝛽2 𝜎𝑧2 2
= 𝜎𝑧
𝛼+𝛽 2
𝛼 2 𝜎𝑣2 + 𝛽2 (0)
2
=0
𝛼+𝛽
𝛼 2 𝜎𝑣2
2
>0
𝛼+𝛽
Case 2: Money Market Shocks
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝑳𝑴∗ 𝑳𝑴∗

𝑳𝑴∗ 𝑳𝑴∗

𝑖∗
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡

𝑰𝑺 𝑰𝑺

𝑌𝑚∗ 𝑌 𝑌𝑚∗∗ 𝑂𝑢𝑡𝑝𝑢𝑡 𝑌∗ 𝑂𝑢𝑡𝑝𝑢𝑡

When 𝑳𝑴 curve is unstable (fluctuates from 𝑳𝑴∗ to 𝑳𝑴∗∗ ’), When 𝑳𝑴 curve is unstable (fluctuates from 𝑳𝑴∗ to 𝑳𝑴∗∗ ’),
money supply target leads output to fluctuate from 𝑌𝑚∗ to 𝑌𝑚∗∗ interest rate leads output to achieve 𝑌 ∗
Case 2: Money Market Shocks
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝑳𝑴∗
▪ When LM is unstable, interest rate target is
preferred.
𝑳𝑴∗ ▪ In other words, if shocks in money market is
larger than shocks in goods market, central
bank should choose interest rate targeting
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡𝑎𝑟𝑔𝑒𝑡 procedure.
▪ Output can be stabilized perfectly by interest
rate target.
▪ If central bank choose a monetary target,
𝑰𝑺 monetary shocks cause the interest rate to
move to maintain money market equilibrium,
𝑌𝑚∗ 𝑌 ∗ 𝑌𝑚∗∗ 𝑂𝑢𝑡𝑝𝑢𝑡 which causes output fluctuations.
Goods and Money Market Shocks

What if both types of shocks occur?

In the case, there is disturbances in both goods and money markets,
then the optimal policy rule depends on (1) size of variances and (2)
relative steepness of IS and LM curves.
𝟐 𝟐
𝑬𝒎 𝒚𝒕 = 𝑬𝒊 𝒚𝒕
𝛼 2 𝜎𝑣2 + 𝛽 2 𝜎𝑧2 2
= 𝜎𝑧
𝛼+𝛽 2
2𝛽 2
𝜎𝑣2 = 1+ 𝜎𝑧
𝛼
Goods and Money Market Shocks

The interest rate rule is more likely to be preferred when the variance of
money market disturbances is larger (𝜎𝑣2 > 𝜎𝑧2 ), the LM curve is steeper
(lower 𝛽) and the IS curve is flatter (bigger 𝛼).
𝑬𝒎 𝒚𝒕 𝟐 > 𝑬𝒊 𝒚𝒕 𝟐

2𝛽 2
𝜎𝑣2 > 1+ 𝜎𝑧
𝛼
Hence, choose an interest rate targeting procedure whenever there is
▪ Relatively high money demand volatility
▪ Relatively low aggregate demand volatility
Remarks on Choosing Instruments

The choice of policy instruments and thus intermediate target depends on

the stochastic structure of the economy (i.e. the nature and different types
of disturbances).
▪ If the main source of disturbance in the economy is shocks to IS curve
or goods market, then targeting money supply (or using money supply
tool) is optimal.
▪ If the main source of disturbance is shocks to demand for money or
financial market, then targeting interest rate is optimal.
▪ Relative variances of macroeconomic shocks matter for optimal choice
of instrument, if both types of shocks occur.
Monetary Policy and Choice of Instrument

Choice of Monetary Instruments

The Poole’s Analysis

Monetary Policy Rules

Rules-Based Monetary Policy

▪ Many central banks conduct their monetary policy through

announcing the policy instrument, which can be based on
monetary target and interest rate target.
▪ A simple and easily communicated rule is thought to be able to
manage the complexity of the economy.
Rules-Based Monetary Policy

A number of scholars recommend a rule that includes a particular

target:
1. Friedman’s k-percent rule for Monetary Target
2. Taylor’s rule for Interest Rate Target
Rule for Monetary Target

A number of scholars recommend a rule that includes a particular

target:
1. Friedman’s k-percent rule for Monetary Target
This rule would increase the supply of money by a certain fixed
percentage per time period, which cannot be changed by the central
bank. The rule draws from the equation of exchange, expressed in
growth rates:
∆𝑚 + ∆𝑣 = ∆𝑝 + ∆𝑦
where 𝑝 , 𝑚, 𝑣, 𝑦 are (the logarithms of) respectively, the price level,
money stock, money velocity and real output.
Rule for Interest Rate Target

A number of scholars recommend a rule that includes a particular

target:
2. Taylor’s rule for Interest Rate Target
Taylor rules are simple monetary policy rules that prescribe how a central
bank should adjust its interest rate policy instrument in a systematic
manner, in response to developments in inflation and macroeconomic
activity.
Rule for Interest Rate Target

A number of scholars recommend a rule that includes a particular

target:
2. Taylor’s rule for Interest Rate Target
Taylor rules provide a useful framework for the analysis of historical
policy and for the econometric evaluation of specific alternative
strategies that a central bank can use as the basis for its interest rate
decisions.
𝑖 = 𝜋 + 𝑟 𝑒 + 𝜙𝜋 𝜋 − 𝜋 ∗ + 𝜙𝑦 (𝑦 − 𝑦 𝑝 )
Where 𝑖 , 𝜋, 𝑟 𝑒 , 𝑦 are respectively, the central bank interest rate, inflation,
central bank equilibrium real interest rate, and real output.
Empirical Illustrations

The Federal Fund Rate and Taylor Rule

The Taylor rule does a reasonable job of explaining Federal Reserve policy during some periods, but it also
shows the periods in which the target federal funds rate diverges from the rate predicted by the Taylor rule.
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