A REVOLUTION in monetary policy attitudes in the past decade—a revolution ignited by that period’s worldwide explosion of prices—has shifted the formulation and assessment of monetary policy from the behavior of interest rates to that of monetary aggregates. Increasingly, monetary authorities are striving to achieve specific, formal or informal, targets for monetary growth. Nevertheless, the behavior of interest rates, both rate levels and volatility, remains an abiding concern of policy. This paper examines the implications of pursuing monetary targets for the behavior of interest rates in the vastly differing economic and political environments found among countries. The paper starts with the case of a financially repressed, closed economy where independent interest rate and money supply targets are, at least in principle, possible. However, even in such economies the degree of this independence is easily overstated. In countries with active (secondary) markets in financial instruments, the existence of which presupposes market-determined interest rates, interest rate targets can be pursued only by subordinating the money supply to that end. Economic liberalization not only precludes independent monetary and interest rate targets, but ultimately makes the independent setting of interest rates impossible, since price level and balance of payments adjustments make the real quantity of money totally market determined. With fixed exchange rates, even the nominal quantity of money is endogenous. Therefore, the paper then turns from setting interest rate levels to the implications of monetary targets for the volatility of market-determined interest rates. It concludes that while monetary targets may increase interest rate volatility somewhat, that increase should be modest.
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Mr. Coats, Senior Economist in the Central Banking Department when this paper was prepared, is currently Chief of the Operations Division for SDRs and Administered Accounts in the Treasurer’s Department. He was formerly Assistant Chairman of the Economics Department at the University of Virginia and is a graduate of the University of California at Berkeley and the University of Chicago. He has published widely on monetary policy issues and coedited, with Deena R. Khatkhate, Money and Monetary Policy in Less Developed Countries (Oxford and New York, 1980).
In several less developed countries, ceilings on deposit rates have resulted in the emergence of substitutes for deposits, with the yield much higher than the stipulated deposit rates (Khatkhate and Villaneuva (1979)). The same holds true for advanced economies such as the United States where efforts to keep bank deposit rates below their equilibrium values have been thwarted by the development of alternative (and often unregulated) intermediaries such as credit unions and mutual funds, but not before seriously distorting the structural development of financial institutions. These interest rate controls must be phased out in the United States by 1986.
By adding fiscal policy (shifts in the IS curve) to monetary policy, it is possible in Hicks’s model to meet both interest rate and money targets.
Many but not all of the points made here are covered in Lombra and Struble, which also contains an excellent bibliography of the relevant literature. The difficulties of achieving money supply control with an interest rate operating strategy are discussed in Coats (1981).
These estimates for a2 did not account for money’s own rate and are therefore biased toward zero, as explained previously in the text above.