Introduction

The objective of New Zealand monetary policy is clear: the Reserve Bank of New Zealand is to achieve and maintain price stability, defined as annual consumer price inflation of between 0 and 2 percent. This is perhaps the most clearly stated and single–focused objective for monetary policy of any country, but the Reserve Bank nonetheless faces the same control problem as other monetary authorities. How should it implement monetary policy to achieve its objective? Is there some intermediate target that will assist in achieving price stability – for instance, a monetary aggregate or the exchange rate?

The choice and use of such an intermediate target form the subject matter of this essay. The discussion is organized as follows. First, some background is provided concerning recent developments in New Zealand monetary policy and the existing monetary framework. Monetary policy is driven directly by the inflation target and is implemented primarily through control of the level of bank reserves via open market operations. In order to guide the setting of the target for bank reserves, inflationary influences (including the impact of monetary aggregate developments) are forecast and bank reserves are then set at a level that will yield an exchange rate band consistent with achieving the inflation target given the other inflationary influences. Thus, the exchange rate is used as a calibration device for setting monetary policy, but neither it nor a monetary aggregate is treated as a target in its own right.