Monetary Policy Targets & Inflation Targeting (Survey of Economics – Chapter 17)

These flashcards review why the Fed must choose between money-supply and interest-rate targets, the concepts of inflation targeting and monetarism, Volcker’s anti-inflation strategy, and the pros and cons of explicit inflation targets.

Why has the Federal Reserve typically chosen the federal funds rate rather than the money supply as its main policy target?

Because the Fed cannot simultaneously target both the money supply and an interest rate; it must choose one and has found the interest-rate target more practical and reliable.

What fundamental limitation prevents the Fed from fixing both the money supply and the market interest rate at the same time?

The market interest rate is jointly determined by money supply and money demand. Once the Fed fixes one of these variables (e.g., the money supply), the other (the interest rate) is left to adjust freely.

During Paul Volcker’s chairmanship, why did the Fed shift its focus from interest rates to money-supply growth?

To reduce high inflation; Volcker believed controlling the growth of the money supply—even at the cost of very high interest rates—was the most direct way to bring inflation under control.

What do monetarists such as Milton Friedman argue the Federal Reserve should target?

The money supply, following a constant monetary-growth rule rather than trying to manage interest rates.

According to monetarists, how should the Fed respond to a recession?

Continue letting the money supply grow at a steady, predetermined rate; do not engage in discretionary expansions or contractions.

Which of the following is NOT a viable monetary policy target for the Fed: money supply, inflation rate, money demand, or interest rate?

Money demand; it is determined by the public and cannot be directly controlled by the Fed.

If the Fed sets the money supply at $900 billion, can it also guarantee a 5 percent interest rate?

No. Fixing the money supply leaves the interest rate to be determined by money demand, so the Fed cannot guarantee a specific rate at the same time.

What is inflation targeting?

A monetary-policy framework in which the central bank publicly commits to achieving a specific, announced rate (or range) of inflation.

List three benefits of adopting an explicit inflation target even if the target is not zero.

1) Greater accountability for the central bank, 2) clearer communication with the public, and 3) more accurate inflation expectations by households and firms.

Which statement is an argument FOR, rather than against, an explicit inflation target?

An explicit target is easier for households and firms to understand, making monetary policy more transparent.

What is a common criticism of explicit inflation targeting with respect to policy flexibility?

It can limit the Fed’s flexibility to respond to other economic problems such as unemployment or financial instability.

When the central bank commits to holding inflation at a publicly announced level, the policy approach is called .

Inflation targeting.

If the Fed pegs the federal funds rate, what happens to the money supply?

The money supply becomes whatever is necessary to keep the interest rate at its target, adjusting endogenously to shifts in money demand.

Which statement about the Fed’s choice of policy targets is correct: the Fed can only choose the interest rate, only the money supply, both simultaneously, or must choose between the two?

The Fed must choose between targeting the interest rate and targeting the money supply; it cannot credibly target both at the same time.