The Process of Monetary Policy Formulation
The factors that guide the policy process
The various lags in the policy process
How and why the performance of the economy can differ from policy makers’ objectives
What intermediate targets are and how they are related to the ultimate policy goals
How monetary policy is formulated by the Federal Open Market Committee (FOMC) and the
major pitfalls of that process
I. Setting the Stage
II. The Policy Process
A. Current Conditions versus Forecasts
B. Assessing the Economic Situation
C. From Assessment to Action
D. From Action to Effect
III. Pitfalls in Policy Making
A. Uncertainty and Lags
B. Globalization: A Financially and Economically Integrated World Economy
IV. Intermediate Targets
A. The Use of Interest Rates as Intermediate Targets
V. Federal Open Market Committee Decisions
Answers to Review Questions
What are the ultimate targets of monetary policy?
The ultimate targets of monetary policy include stable prices, sustainable real gross domestic
product growth, full employment, and satisfactory external balances.
What is an intermediate target? Why does the Fed use intermediate targets instead of
focusing on the ultimate targets? What is an operating target?
An intermediate target is a measurable variable that lies between the operating target that the
Fed uses in the implementation of monetary policy and the ultimate goals.
The intermediate target should be highly correlated with the ultimate target and amenable to
control by the Fed. If the Fed uses such an intermediate target to guide its open market
operations, it will have a greater success rate in achieving its ultimate goals. Intermediate
targets enhance the probability of achieving the ultimate goals.
152 Chapter 26
What is the recognition lag? The policy lag? The impact lag?
The recognition lag is the time elapsed between when a change occurs in the economy’ s
performance and when policy makers recognize that a change has occurred.
The policy lag is the time elapsed between when policy makers recognize that a change in the
economy's performance has occurred and when policy makers decide on and implement an
An impact lag is the time elapsed between when adjustment policy is implemented and when
the economy responds to the policy.
How would the recognition, policy, and impact lags differ with regard to monetary and
fiscal policy? What role does uncertainty play?
The recognition lag should be the same for both monetary and fiscal policy. The policy lag is
generally thought to be shorter for monetary policy. The FOMC is capable of making changes
faster than Congress. The impact lag of monetary policy may also be shorter. Changes in
interest rates may be able to impact economic activity faster than changes in government
spending or taxes. For example, a government spending program on a new highway may take
several years to implement.
Uncertainty plays a key role in assessing policy. Economic forecasts generally contain large
errors, and impacts lags are difficult to mea sure. Also, incoming data may be contradictory.
These factors create uncertainty in policymaking, so policymakers tend to be cautious in
Are current incoming economic data or forecasts more important in guiding monetary
Current economic data is more important than forecasts in guiding monetary policy.
The proportionately large forecasting errors have created a lack of confidence in forecasts;
hence, policy makers rely more heavily on current economic data than forecasts.
When is it most difficult to interpret incoming data? (Hint: Consider the case in which
retail sales are weak, but new orders for capital goods are strong, etc.)
It is more difficult to interpret incoming data when the collection of different individual series
of data reveal conflicting results.
Why can short-term goals sometimes differ from long-term goals?
Short-term goals can differ from long-term goals. For example, if the economy is very far
from the long-term goals, then an adjustment that woul d result in a movement to the long-term
goals in the short term may not be possible. Thus, the short-term goals depend on how far the
economy is from the long-term goals and what can politically be feasible in the short term.
What is an irregular variance? How does it affect Fed behavior?
Irregular variance is a random fluctuation in any data series that makes any single month
movement less reliable as a policy indicator then if a trend continues for several month.
Irregular variance affects the behavior of Fed because it causes the Fed to wait for two to three
The Process of Monetary Policy Formulation 153
months of data to interpret cyclical or trend movements of the economy rather than relying on
month-to-month data only.
What are some common intermediate targets that the Fed has used to guide p olicy in
recent years? Give two criteria for intermediate targets.
The Fed has used the M2 and DNFD aggregates as recent common intermediate targets. In
even more recent years, the Fed has used the level of interest rates as intermediate targets.
An intermediate target must be highly correlated with the ultimate goals of policy. An
intermediate target must also be amenable to control by the Fed.
Why can’t the Fed target both an interest rate and a monetary aggregate simultaneously?
The Fed cannot target both an interest rate and a monetary aggregate simultaneous if there are
changes in the demand for money due to changes in aggregate demand. If the Fed maintains an
interest rate target if the face of a change in the demand for money, it will have to let the
supply of money adjust and hence it will miss its money supply target. If the Fed maintains
the money supply target in the fact of a change in the demand for money it will have to let the
interest rate change and hence miss the interest rate targe t.
Assume the Fed is targeting the money supply and the demand for money falls. Explain
why interest rates will fall.
If the Fed is targeting the money supply and the demand for money falls, there will be an
excess supply of money available at the curr ent interest rate. The interest rate will fall until a
new equilibrium is achieved where the quantity supplied and the quantity demanded of money
Assume the Fed is targeting an interest rate and the demand for money increases. Explain
why the money supply will increase.
If there is an increase in the demand for money, given a fixed money supply, the interest rate
will rise. To keep the interest rate from rising and missing the targeted rate, the money supply
has to increase.
“The Fed should do everything it can to eliminate inflation.” Do you agree? Explain.
Without ignoring or jeopardizing other goals, the Fed should do everything it can to eliminate
inflation. Sometimes, it may not be possible to reduce inflation without severe and politically
unacceptable consequences for employment. Such a situation may result from a severe adverse
supply shock causing both high unemployment and high inflation. In this case, attempts to
eliminate inflation may lead to unacceptable increases in already high unem ployment.
Can using an interest rate as an intermediate target ever have an inflationary bias?
Using interest rates as an intermediate target can have an inflationary effect. If an increase in
the demand for money occurs, the Fed would have to increase the money supply to maintain a
target interest rate. The increase in money supply could lead to inflation.
154 Chapter 26
Answers to Analytical Questions
Find the minutes of the most recent FOMC meeting, either at the library or on the
Internet. (Since the FOMC meets about every six weeks , minutes appear in 8 of the 12
monthly issues of the Federal Reserve Bulletin.) Summarize the policy directive.
The answer to this question will depend on when students take this class.
Assume that the Fed is targeting an interest rate and aggregate d emand drops. Show
graphically why the Fed will have to reduce the supply of money to maintain the
interest rate target.
If the Fed targets the interest rate at X, equilibrium occurs at point A. A drop in aggregate
demand causes the demand for mone y to fall. If the demand for money drops from D to DI
because of a drop in aggregate demand, market forces will be pushing the interest rate down
towards the new equilibrium point B. To maintain the interest rate at X, the Fed must reduce
the money supply from MS to MS1. At the new money supply, the equilibrium is point C and
interest rate is X.
Use a graph to explain why the Fed cannot target both an interest rate and a monetary
aggregate at the same time, assuming that there is a drop in aggregate de mand.
A drop in aggregate demand causes the demand for money to fall. The Fed cannot for maintain
both an interest rate and money supply target in the face of changes in demand. For example,
if the original money supply and interest rate targets are determined by point A, if there is a
drop in demand for money, and if the Fed maintains the money supply target, then the interest
The Process of Monetary Policy Formulation 155
rate will fall to that determined by point B and the Fed will miss its interest rate target. On the
other hand, in the face of a drop in demand, if the Fed maintains the interest rate target as
determined by point A, then it will have to allow the mone y supply to fall to MS1. In either
case, maintaining one target causes the Fed to miss the other target. Therefore, the Fe d cannot
target both an interest rate and an aggregate at the same time.