For example, achieving a particular Federal funds interest rate value might be presumed to induce the level of investment expenditures and aggregate production that results in a business-cycle expansion with low rates of both unemployment and inflation. Alternatively, the monetary authority might deem that targeting a specific growth rate of the M1 monetary aggregate attains this state of the economy.

In a perfect world, the monetary authority could target a variable like M1 or the Federal funds rate to simultaneously achieve full employment, stability, and economic growth. However, in the real world, targeting one variable over others invariably means the pursuit of one goal over others.

Interest Rates

This rate is commonly targeted by the U.S. monetary authority (Federal Reserve System) because:

• It is directly affected by Federal Reserve System monetary policy, specifically open market operations.


• It is a benchmark interest rate that influences the values of most other interest rates in the economy.

However, changes in the Federal funds rate filter throughout the economy, inducing corresponding changes in other interest rates, which then affect macroeconomic activity and the pursuit of full employment, stability, and economic growth.

Monetary Aggregates

A monetary authority like the Federal Reserve System might be inclined to target one of these monetary aggregates. Over the years, the U.S. Federal Reserve System has targeted both M1 and M2 at different times. Targeting is typically implemented by identifying a desired growth rate of the monetary aggregate, which is then translated as a specific value of the aggregate at the end of a period.

If, for example, the current level of M1 is $1 trillion and a 5 percent annual growth rate in M1 is deemed appropriate to achieve the desired macroeconomic goals, then the Federal Reserve System targets a value of M1 at $1.05 trillion by the end of the year.

Although M1, which contains the actual assets used for transactions, would seem to be the logical monetary aggregate target, the Federal Reserve System has preferred to target M2 in recent years. Focus has shifted because M2 has a more stable connection to overall macroeconomic activity. The Federal Reserve System has concluded that achieve a specific M2 value is more likely to generate the desired macroeconomic goals.

Exchange Rates

Exchange rates depend, in part, on the quantity of money an economy has. If an economy with more money in circulation, then like any commodity that is relatively abudandant, the price declines. This means that the exchange rates for a country fall. That is, one dollar might be purchased with 90 yen rather than 100 yen.

Exchange rates are commonly targeted by a monetary authority with an eye toward foreign trade. Lower exchange rates induce exports and limit imports, which stimulate economic activity. Higher exchange rates have the opposite effect.

Some modern nations, especially smaller countries, take this a step further by fixing exchanges rates. In particular, a smaller country implements monetary policy that ensures the exchange rate between their domestic currency and that of another country, usually a larger country like United States, is essentially fixed.

A fixed exchange rate provides a direct link between the two countries, meaning any monetary policy by the larger country affects the smaller one, as well. The smaller country has thus relinquished all monetary policy control to the larger country.

A Mix