Question

In what way does the federal reserve have a high degree of instrument independence? If it has a specific dual mandate from congress to achieve maximum employment and low, stable prices, then how does it have goal independence?

Answer 1

The Federal Reserve has the independence to choose the instrument that is used to achieve its goals. Here, it is possible for the congress or the government to have a goal that is also to be pursued by the Federal Reserve, but the choice of the instrument lies with the Federal Reserve. For example, it is the use of increase in money supply by applying open market operation as a tool, or decreasing the reserve requirements or by decreasing the Federal Fund rates & interest rates. All these instruments work differently, have different level of flexibility as well as ease of use and have different level of effectiveness to achieve the results. In this way, the Federal Reserve has independence to choose the path and plan of action to achieve the target.

The Federal Reserve, government and the congress all work together to complement the policies of each other so that inside and outside lag effect is reduced or eliminated. But, Federal Reserve works independently in the way that tools selection, depends upon the Federal Reserve even if the goals of high employment & stable prices are common in all these institutions. The Federal Reserve can use the OMO to control the money supply that will encourage the aggregate demand and employment. At the same time, the Federal Reserve can increase the Federal fund rates, to discourage the ugly spending. It prevents the price rise in the economy. Hence, it independence should be interpreted in terms of instruments or tools selection, setting short term and medium term targets and making modifications in targets as and when necessary. But, the overall goal of higher level of employment and stable prices remains the same and it is vindicated by the congress and the government.