chapter suggested) in order to create a short-run increase in the interest rate (the opposite of the ultimate goal). This action helps lower inflation, eventually resulting in lower inflation expectations, thereby causing the interest rate to fall.
Another complication faced by the monetary authorities is that the interest rate is no longer a reliable indicator of monetary policy. The preceding chapter suggested that a high interest rate corresponded to a restrictive monetary policy and a low interest rate corresponded to an easy monetary policy. A high interest rate can arise, however, because of high inflation, which can by no stretch of the imagination be due to a restrictive monetary policy. This possibility creates problems for central banks wanting to use the interest rate as a target of monetary policy.
11.4 Policy Implications
Using the interest rate as a target of monetary policy is an important issue, mainly because the Fed has gotten into trouble in the past by doing so (e.g., its use of the federal funds rate as a target during the 1970s). There are two major problems with using an interest rate as a target:
1. The Fed may lose control of the money supply. Suppose for some reason the inflation rate bumps up, and the higher rate soon raises expectations of inflation, thus increasing the nominal interest rate. If the Fed is targeting on an interest rate, it will increase the money supply to push the interest rate back down. This stimulus to the economy will worsen the inflation, and the increase in the money supply will reinforce people's expectations of a higher inflation. Expected inflation rises again, pushing up the nominal interest rate, this time by more than before. The Fed now needs a bigger increase in the money supply to push the interest rate back down, and the process is repeated. Targeting on an interest rate can create a vicious circle, leading the Fed to increase the money supply at an undesirably high rate and creating a high inflation.
2. The approach may destabilize the economy. Suppose the economy is hit with an increase in aggregate demand say, an increase in export demand. The multiplier begins to operate, and income increases. Higher income increases the demand for money, so the interest rate increases, serving as an automatic stabilizer by somewhat decreasing aggregate demand. If the Fed is targeting on the interest rate, it will increase the money supply to prevent the interest rate from increasing, thus preventing this automatic stabilizer from operating.
Do these problems with an interest-rate target mean that the Fed should use a monetary-aggregate growth rate as a target? No. Using a monetary aggregate as a target also has its own serious problems:
1. Measurement problems. With the exception of the money base, monetary aggregates are not reliably measured. Both the M1 and M2 measures experience substantial revisions over time.
