Money, Banking, and Financial Money, Banking, and Financial Markets : Econ. 212Markets : Econ. 212

Stephen G. Cecchetti: Stephen G. Cecchetti: Chapter 15Chapter 15Central Banks in the World TodayCentral Banks in the World Today

Functions of the Central BankFunctions of the Central Bank

1. The Government's Bank1. The Government's Bank The central bank started out as the government’s bank, The central bank started out as the government’s bank,

originally created by rulers to finance wars. However, the originally created by rulers to finance wars. However, the early examples are really the exceptions, as central banking early examples are really the exceptions, as central banking is largely a 20th century phenomenon.is largely a 20th century phenomenon.

The central bank occupies a privileged position: it has a The central bank occupies a privileged position: it has a monopolymonopoly on the issuance of currency. The central bank on the issuance of currency. The central bank creates money and thereby creates money and thereby controls the availability of money controls the availability of money and credit in a country’s economy.and credit in a country’s economy.

Most central banks go about this by adjusting Most central banks go about this by adjusting short-term short-term interest ratesinterest rates, an activity called monetary policy. In today’s , an activity called monetary policy. In today’s world, central banks use monetary policy to world, central banks use monetary policy to stabilize stabilize economic growth and inflationeconomic growth and inflation. .

An expansionary or An expansionary or accommodativeaccommodative (easy money) policy (easy money) policy (lower interest rates) raises growth and inflation; tighter or (lower interest rates) raises growth and inflation; tighter or restrictiverestrictive (tight money) policy reduces them. (tight money) policy reduces them.

Governments want to control the printing of money because Governments want to control the printing of money because it is a very profitable business; also, losing control of the it is a very profitable business; also, losing control of the amount of currency means losing control of inflation.amount of currency means losing control of inflation.

2. The Bankers' Bank2. The Bankers' Bank The most important day-to-day jobs of the central bank are The most important day-to-day jobs of the central bank are

to:to:1.1. provide loans provide loans during times of financial stress (the lender of during times of financial stress (the lender of

last resort).last resort).2.2. manage the payments system manage the payments system (settles inter-bank payments).(settles inter-bank payments).3.3. oversee commercial banks oversee commercial banks and the financial system (handles and the financial system (handles

the sensitive information about institutions without conflicts the sensitive information about institutions without conflicts of interest).of interest).

4.4. By ensuring that sound banks and financial intermediaries can By ensuring that sound banks and financial intermediaries can continue to operate, the central bank continue to operate, the central bank makes the whole makes the whole financial system more stablefinancial system more stable..

Central banks are the biggest and most powerful players in a Central banks are the biggest and most powerful players in a country’s financial and economic system and are supposed to country’s financial and economic system and are supposed to use this power to stabilize the economy, making us all better use this power to stabilize the economy, making us all better off.off.

However, central banks that are under extreme However, central banks that are under extreme political political pressurepressure, or that are simply incompetent, can cause disorder on , or that are simply incompetent, can cause disorder on the economic and financial systems.the economic and financial systems.

A central bank does not:A central bank does not:1.1. control securities markets.control securities markets.2.2. control the government’s budget.control the government’s budget.

The common arrangement today is for the central bank to The common arrangement today is for the central bank to serve the government in the same way that a commercial bank serve the government in the same way that a commercial bank serves a business or an individual.serves a business or an individual.

StabilityStability: : The Primary Objective of All Central Banks. When The Primary Objective of All Central Banks. When economic and financial systems are left on their own they are prone to economic and financial systems are left on their own they are prone to episodes of extreme volatility; central bankers work to reduce that episodes of extreme volatility; central bankers work to reduce that volatility.volatility.

Stability: the primary objective of the Central BankStability: the primary objective of the Central Bank

Central bankers pursue Central bankers pursue five specific objectivesfive specific objectives::

1.1. low and stable inflationlow and stable inflation2.2. high and stable real growth, together with high employmenthigh and stable real growth, together with high employment3.3. stable financial marketsstable financial markets4.4. stable interest ratesstable interest rates5.5. a stable exchange ratea stable exchange rate

Instability in any of those would pose an economy-wide economic risk Instability in any of those would pose an economy-wide economic risk that diversification could not mitigate. Thus the job of the central bank that diversification could not mitigate. Thus the job of the central bank is to improve general economic welfare by managing and reducing is to improve general economic welfare by managing and reducing systematic risk.systematic risk.

It is probably It is probably impossibleimpossible to achieve all five of these to achieve all five of these objectives simultaneously, and so tradeoffs must be made.objectives simultaneously, and so tradeoffs must be made.

1.1. Low, Stable InflationLow, Stable Inflation

Many central banks take as their primary job the Many central banks take as their primary job the maintenance of price stability; they strive to eliminate maintenance of price stability; they strive to eliminate inflation.inflation.

The rationale for keeping the economy inflation-free is that The rationale for keeping the economy inflation-free is that money’s usefulness as a unit of account and as a store of money’s usefulness as a unit of account and as a store of value is enhanced when its purchasing power is maintained.value is enhanced when its purchasing power is maintained.

Inflation degrades the information content of prices and Inflation degrades the information content of prices and impedes the market’s function of allocating resources to impedes the market’s function of allocating resources to their best uses.their best uses.

The higher inflation is, the less predictable it is, and the The higher inflation is, the less predictable it is, and the more systematic risk it creates.more systematic risk it creates.

Also, high inflation is bad for growth.Also, high inflation is bad for growth.

While there is agreement that low inflation should be the While there is agreement that low inflation should be the primary objective of monetary policy, there is no agreement primary objective of monetary policy, there is no agreement on how low inflation should be.on how low inflation should be.

Zero inflationZero inflation is too low, because it brings the risk of is too low, because it brings the risk of deflation (a drop in prices) which in turn results in deflation (a drop in prices) which in turn results in increased defaults on loans and a threat to the health of increased defaults on loans and a threat to the health of banks.banks.

Furthermore, if inflation were zero, an employer wishing to Furthermore, if inflation were zero, an employer wishing to cut labor costs would need to cut nominal wages, which is cut labor costs would need to cut nominal wages, which is difficult to do.difficult to do.

A small amount of inflation may actually make A small amount of inflation may actually make laborlabor markets work bettermarkets work better, at least from the employer’s point of , at least from the employer’s point of view.view.

2.2. High, Stable Real GrowthHigh, Stable Real Growth

Central bankers work to dampen the fluctuations of the Central bankers work to dampen the fluctuations of the business cyclebusiness cycle; booms are popular but recessions are not.; booms are popular but recessions are not.

Central bankers work to moderate these cycles and stabilize Central bankers work to moderate these cycles and stabilize growth and employment by adjusting interest rates.growth and employment by adjusting interest rates.

Monetary policymakers can moderate recessions by lowering Monetary policymakers can moderate recessions by lowering interest rates and can moderate booms by raising them (to interest rates and can moderate booms by raising them (to keep growth at a sustainable level).keep growth at a sustainable level).

Along with growth and employment, stability is also Along with growth and employment, stability is also important, because fluctuations in general business conditions important, because fluctuations in general business conditions are the primary source of systematic risk.are the primary source of systematic risk.

3.3. Financial System StabilityFinancial System Stability

Financial system stability is an integral part of every modern Financial system stability is an integral part of every modern central banker’s job.central banker’s job.

The possibility of a severe disruption in the financial markets The possibility of a severe disruption in the financial markets is a type of systematic risk that central banks must control.is a type of systematic risk that central banks must control.

4.4. Interest Rate and Exchange Rate StabilityInterest Rate and Exchange Rate Stability

Interest rate stability and exchange rate stability are a means Interest rate stability and exchange rate stability are a means for achieving the ultimate goal of stabilizing the economy; for achieving the ultimate goal of stabilizing the economy; they are not ends unto themselves.they are not ends unto themselves.

Interest rate volatility is a problem because:Interest rate volatility is a problem because: it makes output unstable as borrowing and expenditure it makes output unstable as borrowing and expenditure

fluctuate with changing rates.fluctuate with changing rates. it means higher risk and a higher risk premium and makes it means higher risk and a higher risk premium and makes

financial decisions more difficult.financial decisions more difficult.

Even though the exchange rate affects the prices of imports Even though the exchange rate affects the prices of imports and exports, stabilizing exchange rates is the last item on the and exports, stabilizing exchange rates is the last item on the list of central bank objectives. list of central bank objectives.

Different countries have different priorities when it comes to Different countries have different priorities when it comes to the exchange rate; stable exchange rates are more important the exchange rate; stable exchange rates are more important in developing countries because imports and exports are in developing countries because imports and exports are central to their economies.central to their economies.

Meeting the Challenge:Meeting the Challenge: Creating a Successful Central Bank Creating a Successful Central Bank The boom of the 1990s with its associated decrease in The boom of the 1990s with its associated decrease in

volatility may have happened because technology sparked a volatility may have happened because technology sparked a boom just as central banks became better at their jobs.boom just as central banks became better at their jobs.

Policymakers realized that sustainable growth had gone up, Policymakers realized that sustainable growth had gone up, so interest rates could be kept low without worrying about so interest rates could be kept low without worrying about inflation, and central banks were redesigned.inflation, and central banks were redesigned.

Today there is a clear consensus about the best way to design Today there is a clear consensus about the best way to design a central bank and what to tell policymakers to do.a central bank and what to tell policymakers to do.

A central bank must be independent of political pressure, A central bank must be independent of political pressure, accountable to the public, transparent in its policy actions, accountable to the public, transparent in its policy actions, and clear in its communications with financial markets and and clear in its communications with financial markets and the public.the public.

In addition, there is general agreement that policy decisions In addition, there is general agreement that policy decisions are better made by committee than by individuals, and that are better made by committee than by individuals, and that everyone is well served when policymakers operate within everyone is well served when policymakers operate within an explicit framework that clearly states their goals and the an explicit framework that clearly states their goals and the tradeoffs among them.tradeoffs among them.

The Need for IndependenceThe Need for Independence The idea that central banks should be independent of The idea that central banks should be independent of

political pressure is a new one, because central banks political pressure is a new one, because central banks originated as the governments’ banks.originated as the governments’ banks.

Independence has two components: monetary policymakers Independence has two components: monetary policymakers must be free to control their own budgets and the bank’s must be free to control their own budgets and the bank’s policies must not be reversible by people outside the central policies must not be reversible by people outside the central bank.bank.

Successful monetary policy requires a long time horizon, Successful monetary policy requires a long time horizon, which is inconsistent with the need of politicians to focus on which is inconsistent with the need of politicians to focus on short-term goals.short-term goals.

Given a choice, most politicians will choose monetary Given a choice, most politicians will choose monetary policies that are too accommodative, keeping interest rates policies that are too accommodative, keeping interest rates low and money growth rates high. While this raises output low and money growth rates high. While this raises output and employment in the near term it may result in inflation and employment in the near term it may result in inflation over the longer term.over the longer term.

To insulate policymakers from the daily pressures faced by To insulate policymakers from the daily pressures faced by politicians, governments have given central banks control of politicians, governments have given central banks control of their own budgets, authority to make irreversible decisions, their own budgets, authority to make irreversible decisions, and appointed them to long terms.and appointed them to long terms.

Decision-Making by CommitteeDecision-Making by Committee In the course of normal operations, it is better to rely on a In the course of normal operations, it is better to rely on a

committee than on an individual.committee than on an individual. Pooling the knowledge, experience, and opinions of a group Pooling the knowledge, experience, and opinions of a group

of people reduces the risk that policy will be dictated by an of people reduces the risk that policy will be dictated by an individual’s quirks, not to mention that in a democracy, individual’s quirks, not to mention that in a democracy, vesting so much power in one individual poses a legitimacy vesting so much power in one individual poses a legitimacy problem.problem.

The Need for Accountability and TransparencyThe Need for Accountability and Transparency Central bank independence is inconsistent with Central bank independence is inconsistent with

representative democracy.representative democracy.

To solve this problem, politicians have established a set of To solve this problem, politicians have established a set of goals and require the policymakers to report their progress goals and require the policymakers to report their progress in pursuing these goals.in pursuing these goals.

The Policy Framework, Policy Trade-offs, and CredibilityThe Policy Framework, Policy Trade-offs, and Credibility The monetary policy framework is made up of the objectives The monetary policy framework is made up of the objectives

of central banks and the requirements that central banks be of central banks and the requirements that central banks be independent, accountable, and good communicators.independent, accountable, and good communicators.

The monetary policy framework exists to resolve the The monetary policy framework exists to resolve the ambiguities that arise in the course of the central bank’s ambiguities that arise in the course of the central bank’s work and also clarifies the likely responses when goals are in work and also clarifies the likely responses when goals are in conflict with one another.conflict with one another.

Central bankers face the tradeoff between inflation and Central bankers face the tradeoff between inflation and growth on a daily basis.growth on a daily basis.

Since policy goals often conflict, central bankers must make Since policy goals often conflict, central bankers must make their priorities clear.their priorities clear.

A well-designed policy framework also helps policymakers A well-designed policy framework also helps policymakers establish establish credibility.credibility.

IV. Fitting Everything Together: Central Banks and Fiscal IV. Fitting Everything Together: Central Banks and Fiscal PolicyPolicy

The central bank does not control the government’s budget; The central bank does not control the government’s budget; fiscal policy (the decisions about taxes and spending) is the fiscal policy (the decisions about taxes and spending) is the responsibility of elected officials.responsibility of elected officials.

While fiscal and monetary policymakers share the same While fiscal and monetary policymakers share the same ultimate goal of improving the well-being of the population, ultimate goal of improving the well-being of the population, conflicts can arise between the two.conflicts can arise between the two.

Funding needs create a natural conflict between monetary and Funding needs create a natural conflict between monetary and fiscal policymakers.fiscal policymakers.

Fiscal policymakers also tend to ignore the long-term Fiscal policymakers also tend to ignore the long-term inflationary effects of their actions.inflationary effects of their actions.

Politicians often turn to borrowing (instead of taxes) as a way Politicians often turn to borrowing (instead of taxes) as a way to finance some portion of their spending, but a country can to finance some portion of their spending, but a country can issue only so much debt.issue only so much debt.

Inflation is a real temptation to shortsighted fiscal Inflation is a real temptation to shortsighted fiscal policymakers because it is a way to get money in their hands policymakers because it is a way to get money in their hands and it’s a way for governments to default on a portion of the and it’s a way for governments to default on a portion of the debt they owe.debt they owe.

The founders of the European Monetary Union wanted to The founders of the European Monetary Union wanted to ensure that participating governments kept their fiscal houses ensure that participating governments kept their fiscal houses in order (so that none of them would be tempted to pressure in order (so that none of them would be tempted to pressure the European Central Bank to create inflation and then bail the European Central Bank to create inflation and then bail them out) and so they established criteria countries had to meet them out) and so they established criteria countries had to meet for inclusion.for inclusion.

Responsible fiscal policy is essential to the success of monetary Responsible fiscal policy is essential to the success of monetary policy.policy.

Lessons of Chapter 15Lessons of Chapter 15

1. The functions of a modern central bank are to:1. The functions of a modern central bank are to: adjust interest rates to control the quantity of money and credit in the economy;adjust interest rates to control the quantity of money and credit in the economy; operate a payments system;operate a payments system; lend to sound banks during times of stress; andlend to sound banks during times of stress; and oversee the financial system.oversee the financial system.

2. The objective of a central bank is to reduce systematic risk in the economic and 2. The objective of a central bank is to reduce systematic risk in the economic and financial system. Specific objectives include:financial system. Specific objectives include: low and stable inflation;low and stable inflation; high and stable growth and employment;high and stable growth and employment; stable financial markets and institutions;stable financial markets and institutions; stable interest rates; andstable interest rates; and stable exchange rates.stable exchange rates.

Because these objectives often conflict, policymakers must have clear priorities.Because these objectives often conflict, policymakers must have clear priorities.3. The best central banks:3. The best central banks:

a.a. are independent of political pressure;are independent of political pressure;b.b. make decisions by committee rather than by an individual;make decisions by committee rather than by an individual;c.c. are accountable to elected representatives and the public;are accountable to elected representatives and the public;d.d. communicate their objectives, actions, and policy deliberations clearly to the public;communicate their objectives, actions, and policy deliberations clearly to the public;e.e. articulate clearly how they will act when their goals conflict; andarticulate clearly how they will act when their goals conflict; andf.f. are credible in their efforts to meet their objectives.are credible in their efforts to meet their objectives.

4. Fiscal policy can make the central bank’s job impossible because:4. Fiscal policy can make the central bank’s job impossible because:a.a. politicians take a short-term view, ignoring the inflationary impact of their actions over politicians take a short-term view, ignoring the inflationary impact of their actions over

the long term;the long term;b.b. politicians are predisposed toward financing techniques that will create inflation;politicians are predisposed toward financing techniques that will create inflation;

inflation not only provides immediate revenue; it reduces the value of the government’s inflation not only provides immediate revenue; it reduces the value of the government’s outstanding debt;outstanding debt;

c.c. responsible fiscal policy is a precondition for successful monetary policy; andresponsible fiscal policy is a precondition for successful monetary policy; and central banks remain independent at the pleasure of politicians.central banks remain independent at the pleasure of politicians.