When looking at targets, you will find that this is very important for economies to evaluate. If the Fed was to conduct targets, it will make their job a little bit more transparent. How effective would their policies to help stabilize our economy?
Inflation or Interest Rates
When looking at the Fed, you will find that they are trying to measure both inflation and interest rate changes. What is more important for them to monitor and target, inflation or interest rates?© BrainMass Inc. brainmass.com December 24, 2021, 11:03 pm ad1c9bdddf
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Targeting is espoused by most economists, because it sets rules in motion rather than discretion (there is a large body of economics literature looking at "rules versus discretion"). It provides predictability, making decisions easier in the economy, and does indeed make the Fed's work more transparent. There are obviously disagreements on what to target. Monetarists believe that the money supply itself should be targeted (growing at a rate of 2% per year), while neoclassical economists tend towards inflation targeting and Keynesians believe that growth or unemployment should also be targeted. The worry that Central Bankers have about targeting is what happens when a major crisis or systemic failure develops. If they abandon targeting to solve the crisis, they may lose the credibility that has been built up during the targeting phase. This will also introduce uncertainty into the economy. On the other hand, targeting may be useless in an environment that is rapidly in flux (as in transition economies) or in a downward spiral (such as in Zimbabwe). Finally, there is a LARGE literature in economics that says central bankers and politicians always have an incentive to inflate (it may raise employment or decrease the real burden of deficits). Targeting would take away, in theory, this temptation, because they would have committed to targets and to not inflate at a whim.
Inflation or Interest rates
It it easier for the Fed to target interest rates because it is one of the direct levers that they control (changing the price of money for banks in the US) rather than inflation. Targeting inflation is more difficult, as inflation occurs because of money supply changes but takes time to work its way through the real economy in the form of price rises. Thus, when targeting inflation, there is a lag between the change in the policy lever (open market operations, interest rates, reserve requirements) and the effects - and so a policy could be kept in place longer than desirable.
However, targeting interest rates is also dangerous for the Fed to target, as it alters the price of capital and the time value of money. By changing interest rates, the Fed is saying that the value of a future dollar is worth more/less, and this also alters future incentives and decisions of businesses in the economy. If their changes in targeting the interest rate are very far off from the fundamentals of the economy, they may end up doing more harm than good. Also, interest rates are bounded by zero, in that you can't go less than a zero interest rate. Other ploys to get around this may seriously damage the economy (see Japan in the 1990s and the current asset-backed securities buying binge of the Fed), and thus you can only drive interest rates so low. Inflation, on the other hand, can unwind (deflation) and turn negative.© BrainMass Inc. brainmass.com December 24, 2021, 11:03 pm ad1c9bdddf>