Explain why the FED cannot set intermediate targets in terms of both monetary aggregates and interest rates.
The Federal Reserve, or the FED, is responsible for managing the monetary policy of the United States. One approach to monetary policy is to set intermediate targets, which are goals for both monetary aggregates (such as the money supply) and interest rates. However, there are reasons why the FED cannot solely rely on intermediate targets and must take a more comprehensive approach.
1. Complexity and Uncertainty: The economy is a dynamic and complex system with various interdependencies. Setting intermediate targets for both monetary aggregates and interest rates can be challenging because these variables do not always move in the same direction or in a predictable manner. Economic conditions and financial markets can change rapidly, making it difficult to align both targets.
2. Conflicting Objectives: Monetary aggregates and interest rates may not always align with the FED's broader goals. The FED's primary objectives include maintaining price stability, achieving maximum employment, and supporting economic growth. In certain situations, focusing solely on monetary aggregates or interest rates may lead to trade-offs or conflicts with these objectives.
3. Indirect Transmission Mechanism: While changes in monetary aggregates and interest rates can influence economic conditions, the relationship is not always straightforward. The impact of changes in monetary aggregates on the real economy can vary based on factors like financial intermediation and lending standards. Similarly, interest rates affect various sectors differently, and their transmission mechanism can be complex. Thus, solely relying on these targets might not capture the full impact on the economy.
4. External Factors: The FED's ability to control both monetary aggregates and interest rates is influenced by external factors beyond its control. These include global economic conditions, exchange rates, and financial market developments. Setting intermediate targets for both variables could overshadow the impact of these external factors, limiting the effectiveness of monetary policy.
Due to these reasons, the FED adopts a more flexible approach by considering a broad range of economic indicators and using a variety of tools to achieve its goals. This helps ensure that monetary policy decisions take into account the complexities of the economy, the FED's objectives, and the impact on various sectors.