Choice between Money Supply and Interest Rate Targets

Let us make an in-depth study of the Choice between Money Supply and Interest Rate Targets.

1. Uncertainty:

The main consideration affecting the choice between the money supply (monetary aggregate) target and the interest rate as an intermediate target is the uncertainty faced-by the monetary authorities.

If uncertainty is due to unpredictable shift of the IS curve caused by sudden and unexpected shift in private investment (in fixed assets and in residential construction) and consumer purchases of durable goods, a money supply target is superior to an interest-rate target.

The interest-rate target is preferable when there is uncertainty about shifts of the LM curve caused by unstable money demand. The LM curve shifts if there is a change in asset preference (shift of asset demand from money to one composite, non-money asset called bonds or from bonds to money), in which case the interest rate is the superior intermediate target.

2. Credibility:

One extra advantage for a money supply target is that a strong commitment to keeping money supply growing in a target range ensures control of inflation for medium- term periods (3-5 years) inasmuch as sustained high inflation requires accommodating money supply growth. If money supply targets are strictly adhered, monetary accommodation is severely limited unless the targets are themselves high.

This means that by setting new, non-inflationary money supply targets, and hitting them, the central banks can build up anti-inflationary credibility. Reputation is a big factor here. If the public starts to believe that the central bank will carry out announced policies, inflationary expectations can be kept at a low level.

No such anti-inflationary guarantee can be provided by an interest-rate target. Even repeatedly hitting interest-rate targets does not necessarily build up the credibility of the central bank’s monetary policy. If the central bank targets the interest rate, it must increase the money supply to accommodate any increases in money demand.

If a potential boom begins, money demand will increase (due to rise in transactions demand). The central bank may then be forced to fuel the inflationary fire, reluctantly though, by an accommodating increase in the money supply.