Money Supply Target
Given the fixed money supply, transactions in bonds will generate changes in r.
(e.g. ↑ Y, ↑ Md, with fixed Ms, Sell bonds, Bp ↓, r ↑)
Interest rate target
Interest rate target is inferior because as demand for money varies, the central bank will buy or sell bonds (to raise or lower money supply respectively) as a means of maintaining a given r0 so that demand change is met and no restraint or ↑ or ↓ of Y.
Compare
Money supply target is preferred to interest rate target. On the diagram above we can see that by pursuing a money supply target a lower variance in respect to income and employment is achieved than if an interest rate target is achieved.
Money market instability
Equilibrium with interest target r0
Money
supply target
When money market instability occurs we do not know the position of the LM curve. Money market instability means changes in money demand cause shifts in the LM curve which in turn change Y.
Money supply target
In the diagram:
Money demand falls- excess supply- people buy bonds - LM shifts right – increase income- decrease interest rate
Money demand increases- excess demand- people sell bonds - LM shifts left- decrease income- increase interest rate
In each case (increase and decrease money demand), the excess (money demand and money supply) will give rise to transactions in bonds, causing interest rate and income to change.
Interest rate target
With an interest rate target the central bank varies the money supply (by buying and selling bonds) at a chosen interest rate so that changes in money demand are met. The LM schedule is horizontal and does not shift when there is a shock of money demand, so there is a stable equilibrium with an interest rate target. Therefore there are no effects in the goods market, so that Y is maintained at its previous level. Therefore there is a constant equilibrium point of Y (shown on diagram).
For example, negative shock: if money demand fell, there would be an excess money supply. This would increase the demand for bonds. This increase in demand for bonds would be met by the central bank which sells bonds in exchange for the excess money, at a fixed Bond price/interest rate. Real Y remains at original equilibrium.
Another example, a positive shock: Desirable new type of bank deposit: increase money demand at a given level of Y and r, excess money demand, met by increase supply of bonds by the Central Bank. Real Y remains at equilibrium.
Compare
In this case an interest rate target performs better that a money supply target. On the diagram we can see that by pursuing an interest rate target, there is no variance in respect to income and employment compared with money supply target, where some variance is achieved.
Conclusion (p398 Froyen)
The important consideration in choosing between money supply target and interest rate target is whether the source of uncertainty faced by the monetary policymaker lies in the goods or the money market. If the uncertainty lies in the goods market, a money supply target is superior to an interest-rate target. The implication for the actual economy is that, when uncertainty comes from sources such as unpredictable shifts in the business sector’s investment spending, residential construction investment, and consumer durable purchases- all private sector demands for output- the money supply target is preferable
The interest rate target was seen to be superior when uncertainty stemmed from money market uncertainty. In the IS-LM model, assets are split into 2 groups: one termed money and one composite, nonmoney asset termed bonds. Any factors that change the relative desirability of the 2 assets shifts the LM curve. The implication for the actual economy is that when the predominant source of uncertainty centres on shifts in asset demands (for bonds and money), the r target is superior.
I don’t think this bit now is that relevant for this particular question, but it’s in our notes and if you don’t have the notes from the last diagram you might not have this either:
Normally associate:
- Monetarists with money supply target and use of monetary policy passively
- Keynes with interest rate target and use of fiscal policy actively
Our analysis would support the monetarists as they argue money demand is stable but goods market subject to unpredictable shifts (shocks). Keynes fears goods market instability because of volatility of investment due to changing expectations under uncertainty, so Keynes should employ a money supply target.
