Instrument Choice for Money Stock Control with Contemporaneous and Lagged Reserve Requirements: Note

Abstract

This paper assumes that an economy's monetary author1ty wishes to achieve accurate control of the stock of money and asks whether that goal can be more fully accomplished by means of an operating procedure that manipulates interest rates or reserve aggregates. While a sizable number of papers on the subject has been published, 1 we believe this is the first to utilize a model that treats output and prices as endogeneous, is explicitly dynamic, and incorporates rational expectations. Given recent interest in monetary control issues, it is striking that no such analysis has previously been conducted. A likely reason is that until very recently it appeared that the values of all nominal magnitudes will be indeterminate in most rational expectations models if the monetary authority uses an interest rate as its operating instrument. This appearance was fostered by a result in the well-known paper of Sargent and Wallace [9] and by recognition that similar results hold in other rational expectations models, including ones without the policy ineffectiveness property.2 It is shown in [5], however, that this indeterminacy does not prevail if an interest rate instrument is used but in a manner that is designed to have some desired effect on the expected quantity of money in some future period that is, if some weight is given to a nominal target. Thus, it is in fact possible to conduct an analytical comparison of the type desired, even in a model entirely free of money illusion and expectational irrationality. In the context of the instrument-choice issue, it is crucial to distinguish between