476 PA R T V Central Banking and the Conduct of Monetary Policy TACTI CS: CHO OSI N G T HE P O LI CY I N ST RUM E NT Now that we are familiar with the overall strategies for monetary policy, let s look at how monetary policy is conducted on a day-to-day basis Central banks directly control the tools of monetary policy open market operations, government deposit shifting, last-resort lending, and the overnight interest rate but knowing the tools and the strategies for implementing a monetary policy does not tell us whether it is easy or tight The policy instrument (also called an operating instrument) is a variable that responds to the central bank s tools and indicates the stance (easy or tight) of monetary policy A central bank like the Bank of Canada has at its disposal two basic types of policy instruments: reserve aggregates (total reserves, nonborrowed reserves, the monetary base, and the nonborrowed base) and interest rates (overnight interest rate and other short-term interest rates) (Central banks in small countries can choose another policy instrument, the exchange rate, but we leave this topic to Chapter 20.) The policy instrument might be linked to an intermediate target, such as a monetary aggregate or a long-term interest rate Intermediate targets stand between the policy instrument and the goals of monetary policy (e.g., price stability, output growth); they are not as directly affected by the tools of monetary policy, but might be more closely linked to the goals of monetary policy As a study aid, Figure 18-2 shows a schematic of the linkages between the tools of monetary policy, policy instruments, intermediate targets, and the goals of monetary policy As an example, suppose the central bank s employment and inflation goals are consistent with a nominal GDP growth rate of 5% The central bank might believe that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M2 (an intermediate target), which will in turn be achieved by a growth rate of 3% for nonborrowed reserves (the policy instrument) Alternatively, the central bank might believe that the best way to achieve its objectives would be to set the overnight interest rate (a policy instrument) at, say, 4% Can the central bank choose to target both the nonborrowed-reserves and the overnight-interest-rate policy instruments at the same time? The answer is no The application of supply and demand analysis to the market for reserves we developed in Chapter 17 explains why a central bank must choose one or the other Let s first see why an aggregate target involves losing control of the interest rate Figure 18-3 contains a supply and demand diagram for the market for reserves Although the central bank expects the demand curve for reserves to be at R d *, it fluctuates between R d + and R d ++ because of changes in banks desire to hold reserves If the central bank has a nonborrowed-reserves target of NBR * (say, because it has a Tools of the Central Bank Open Market Buyback Operations Central Bank Lending Settlement Balances Management Receiver General Auctions Policy Instruments Intermediate Targets Reserve Aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base) Monetary Aggregates (M1, M2) Interest Rates (short-term such as overnight funds rates) F I G U R E 18 - Interest Rates (short-term and long-term) Goals Price Stability High Employment Economic Growth Financial Market Stability Interest-Rate Stability Foreign Exchange Market Stability Linkages Among Central Bank Tools, Policy Instruments, Intermediate Targets, and Goals of Monetary Policy