Question

“Interest rates can be measured more accurately and more quickly than money supply. Hence interest rate is preferred over the money supply as an intermediate target”. Do you agree or disagree? Explain you answer. (500 words)

Answer 1

SOLUTION:-

Measurability of interest rates vis-a-vis reserve aggregates:

* Reserve aggregates like nonborrowed reserves are straightforward to measure, but there is still some lag in reporting of reserve aggregates (one or two weeks).

* Short-term interest rates, like the federal rate, are not only easy to measure but can also be observed quickly.

* However, short-term interest rates are nominal values.

* They are a poor measure of the real cost of borrowing, which indicates with more certainty what will happen to real GDP.

* The real interest rate, ir, being equal to the normal interest rate / less expected inflation, Pe, represents the true cost of borrowing.

* However, it is difficult to measure as there is no direct way to measure expected inflation.

* Thus, it is uncertain whether interest rates will serve as a better policy instrument than reserve aggregates on grounds of measurability.

Thus, the assertion that interest rates are preferred over reserve aggregates as a policy instrument due to better measurability is false.

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