Topic two: interest rate approach VS money supply approach, Poole’s model
T221 bof:
P 65, P 325
As illustrated by the graph, for a given demand for central bank money by the banks, there will always be a fixed relationship between monetary base and the money market rate. The central bank’s decision to aim at a particular target value for the money market interest rate thus directly implies a particular amount of central bank money. Conversely, a central bank that is pursuing a fixed target for the level of central bank money is no longer free to determine the interest rate level on the money market.
Interest rate targeting is always preferable to monetary base targeting when, for at least some of the time, a necessary condition for implementing the chosen approach is stability in the money market rate. This is clearly the case when a central bank pursues a policy in which it seeks to control the price level directly via money market interest rates (inflation targeting). Interest rate targeting is also essential when the exchange rate is being used as an intermediate monetary policy target. Owing to the interest parity condition, short term fluctuations in money market rates can have a direct influence on the spot rate. Thus, shocks affecting banks’ demand for central bank money could, in the case of monetary base targeting, lead to erratic interest rate movements and hence to destabilizing capital flows and disruptive exchange rate fluctuations. It is obvious that a perfect control of short term interest rates is required.
On the other hand, monetary base targeting is clearly superior to interest rate targeting when a central bank has decided to adopt nominal GDP targeting. In this case, interest rate targeting could lead to undesirable fluctuations in the monetary base.
The choice is less obvious when a central bank follows the rule of monetary targeting. Although monetarists often show a preference for monetary base targeting, it can be demonstrated that it is not automatically to be regarded as superior to interest rate targeting.
According to Poole’s model, when targeting the money stock the assessment of which of the two methods is superior will depend essentially on the nature and intensity of the expected shocks.
1. interest rate targeting is preferable to monetary base targeting when shocks occur mainly in the money multiplier. These can be caused either by fluctuations in the cash holding ratio or ---- in a system without minimum reserves ---- by variations in the voluntary reserves held by the banks. In this case interest rate targeting allows an automatic adjustment in the monetary base, which fully offsets the disturbance in the multiplier.
2. monetary base targeting is superior to interest rate targeting when the monetary disturbances principally affect either private individuals’ demand for money or bank lending, while the multiplier is relatively stable. When the monetary base is being targeted, an endogenous adjustment in the money market rate helps to prevent such disturbances from having an effect on the money supply.
Thus, a central bank pursuing a policy of monetary targeting would have to consider what types of disturbance are most likely to occur. In reality, the very low short term interest elasticity of the demand for base money makes it almost impossible to pursue strict monetary base targeting as an operating procedure for monetary targeting.
From the two main targeting approaches briefly outlined here, it is clear what practical criteria the overall range of monetary policy instruments must satisfy when a central bank has to decide between these two options.
1. monetary base targeting requires that the central bank should be able at all times to control the assets side of its balance sheet in such a way that it cannot be forced to expand the monetary base involuntarily.
2. interest rate targeting requires that the central bank should have access to instruments that set a strict upper and lower limit at all times on market-induced fluctuations in the money market rate. Because of the interdependent relationship between the monetary base and the money market rate, this strategy too requires some degree of control over the assets side of the central bank’s balance sheet.
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