Chapter 15 Central Banks in the World Today Chapter Fifteen Chapter 15 Central Banks in the World Today

Learning Objectives Functions and objectives of central banks. Features of an effective central bank. Fiscal challenges for central banks.

Central Banks There are about 170 central banks in the world today. Nearly every country has one. Interestingly, central banking is largely a 20th-century phenomenon. In 1900, only 18 countries had central banks. When the Soviet Union collapsed in 1990, the 12 of the 15 republics had central banks within a year If we think back to Chapter 11 when we discussed moral hazard, discuss how a government ceding the right to control the amount of currency to a central bank is way to treat a potential moral hazard problem. Answer: Government officials have a variety of options available to finance their expenditures; these include taxation, borrowing and printing money. The printing of money, though inflationary, would allow these officials to avoid the short term problems of raising taxes and or borrowing, which may reduce their chances of holding on to their office, and by printing money, the problem of inflation may not occur until they are out of office. This creates a potential moral hazard for elected officials, which is removed by giving the power to print money to an independent central bank.

Web Links www.bis.org

Role of the Central Bank: “The Government’s Bank” Manage the finances of the government. Control the availability of money and credit. They create money. Conduct monetary policy, expansionary/tight Think back to Chapter 11 when we discussed moral hazard. Discuss how a government ceding the right to control the amount of currency to a central bank is a way to treat a potential moral hazard problem? Answer: Government officials have a variety of options available to finance their expenditures; these include taxation, borrowing and printing money. The printing of money, though inflationary, would allow these officials to avoid the short term problems of raising taxes and or borrowing, which may reduce their chances of holding on to their office, and by printing money, the problem of inflation may not occur until they are out of office. This creates a potential moral hazard for elected officials, which is removed by giving the power to print money to an independent central bank.

Role of the Central Bank: “The Banker’s Bank” Three important day-to-day functions of the central bank Manage the payments system (settle inter-bank payments). Provide loans during times of financial stress (the lender of last resort credit facilities). Oversee commercial banks and the financial system to ensure confidence in their soundness (regulatory oversight).

What a Central Bank is Not In the US, the Fed does not control securities markets, though it may monitor and participate in bond and stock markets. The Fed does not control the government’s budget. That is determined by Congress and the president through fiscal policy. The Fed only acts as the Treasury’s bank.

Stability: The Primary Objectives of all Central Banks Low, stable inflation High, stable growth with high employment stable financial markets interest rate stability exchange rate stability How do the specific goals of interest rate and exchange rate stability differ in importance from the other specific goals mentioned for central bankers? Answer: As the text mentions, interest rate and exchange stability are secondary to the goals of stable growth, low inflation, and financial stability. The main reason offered is that interest and exchange rate stability are a means to obtain the other goals. While no central banker wants volatile interest rates, they often times will use the interest rate to achieve one or more of the other goals. Provide an example where monetary policymakers in the United States would be put in a position of conflicting goals and as a result forced to make a tradeoff. Answer: We can borrow one from the text. The economic recession that began in early 2001 and was further fueled by the terrorist acts of September 11 of that same year, saw a slowdown in the growth rate of the economy and high stable rates of growth is one of the Fed's objectives. In order to minimize the slowdown the Fed lowered the short term interest rate eleven times in just over eleven months. This conflicted with the goal of stable interest rates, and potentially with the goal of price stability. This is a situation where goals conflicted and the Fed was forces to choose one goal at the expense of the other. A tradeoff was made.

Should Price Stability be the Primary Goal? The Federal Reserve has a dual mandate. The boxed items on the previous slide In the short run, price stability can conflict with the goal of high employment. Conflicting goals implies trade-off ECB has a hierarchical mandate, price stability first, then growth. Other countries have a legislative price stability mandate

Why is Low and Stable Inflation Desirable? Money ceases to function as a store of value, unit of account or medium of exchange with high inflation. High inflation is associated with unpredictable inflation and makes bonds risky. In this environment nominal interest rate = real interest rate + expected inflation + risk premium. Long-term planning difficult Home Mortgage Retirement planning.

US. Inflation From 1970

Low Inflation - How Low Should Low Be? No agreement on this. Zero inflation is probably too low. - risk of deflation which in turn results in defaults on loans and a threat to the health of banks. - inflation measures are biased. Some countries have explicit inflation targets - generally at 2%. The US does not have an explicit inflation target. Should there be one? What are the potential problems that can result if central bankers set a target of a zero rate of inflation? Answer: A zero inflation target has a few problems. First, trying to hit a zero target risks deflation occurring. Deflation has a lot of problems including making debts more difficult to repay which can lead to an increase in loan defaults and an adverse impact on the health of banks. Deflation also increases information problems for lenders so it will be more difficult for borrowers, even creditworthy ones, to obtain loans. In addition, a zero rate of inflation would require a firm to actually cut nominal wages if it needed to reduce labor costs. If the inflation rate is positive, as long as nominal wages are constant or are increasing at a lower rate than inflation, real wages will fall. Finally, most economists agree that inflation i

High & Stable Real Growth The idea is that there is some long-run normal level of production called potential output, which depends on things like Technology, The size of the capital stock, The number of people who can work, and hours worked. Growth in these inputs leads to growth in potential output -- sustainable growth.

High & Stable Real Growth The economy cycles above and below this long-run potential growth. A role of the central bank is to change interest rates to adjust growth. In the long run, stability leads to higher growth.

High & Stable Real Growth Data shows stable countries grow faster unstable growth adds risk risk drives up interest rates higher interest rates mean lower investment lower investment means lower growth

US GDP Growth Rate from 1960

Stable Financial Markets - Financial System Stability The Fed was founded to stop the financial panics that plagued the U.S. during the late 19th and early 20th centuries.

Stable Financial Markets Financial collapse of the 1930s. Fed’s actions under Greenspan 1987, 1997, 2001 Fed’s actions under Bernanke Yellen’s primary concern is growth Central banks want to minimize the risk of a disaster - keep the probability of maximum loss as small as possible. - Value-at-Risk

Interest-Rate and Exchange-Rate Stability In the US, these goals are secondary to those of low inflation, stable growth, and financial stability. In the hierarchy, interest-rate stability and exchange-rate stability are means for achieving the ultimate goal of stabilizing the economy. They are not ends unto themselves.

Exchange-Rate Stability The value of a country’s currency affects the cost of imports to domestic consumers and the cost of exports to foreign buyers. When the exchange rate is stable, the price of goods is predictable and planning ahead is easier for everyone. For emerging market countries, exports and imports are central to the structure of the economy. Stable exchange rates are very important.

Creating a Successful Central Bank To be successful, a central bank must: be independent of political pressure, make decisions by committee, be transparent in communicating its policy actions and accountable to the public, and operate within an explicit framework that clearly states its goals and makes clear the trade-offs among them.

The Need for Independence To keep inflation low, monetary decisions must be made free of political pressure. Politicians have an incentive to create short-term prosperity (print money) at the expense of inflation tomorrow. Longer time horizon needed to avoid “inflation bias” Central bank policy makers must think in terms of long-term inflation. Knowing these tendencies, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution. Most military historians will point out that successfully-waged battles and wars are often the result of having an exceptional individual in charge. At the same time, it seems that monetary policymaking seems to do well when policy is made by a committee. Contrast the two situations and discuss why a committee for monetary policymaking would be superior. LOD: 3 Page: 389 Answer: First of all, monetary policy is serious business but it is not war. Often times a battle requires that decisions be made quickly and there is little or no time for discussion so decisions are made by the person with the most authority and carried out. With monetary policy the time restrictions aren't so tight, and the time horizon is much longer. As a result, there is room and time for discussion. Also, the scope of the situations is different. A war or a battle has a specific scope in terms of the people immediately impacted, the causes for the battle etc. With economic matters and monetary policymaking there are many variables involved and most times not everyone is going to agree on what is wrong, what variables should be considered and what the possible remedies may be, again obtaining many viewpoints could be valuable. In the few cases discussed in the text, such as September 11th, 2001, actions by members of the Fed probably closely resembled a military response, very quick, very clear and to the point.

The Need for Independence What is needed for Independence Monetary policymakers must be free to control their own budgets. Central bank policies must not be reversible by people outside the central bank. The U.S. Federal Open Market Committee’s decisions cannot be overridden by the President, Congress or the Supreme Court.

The Need for Independence The Fed’s took extraordinary actions during the crisis of 2007-2009 which led to political backlash against Fed independence. Hopefully congress will not choose to sacrifice the hard-won gains on the inflation front by weakening Fed independence.

Decision Making by Committee Pooling the knowledge, experience, and opinions of a group of people reduces the risk that policy will be dictated by an individual’s quirks. Vesting so much power in one individual also poses a legitimacy problem. Therefore, monetary policy decisions are made by committee in all major central banks in the world.

The Need for Accountability and Transparency Politicians establish a set of goals. Policymakers publicly report their progress in pursuing those goals. Explicit goals foster accountability and disclosure requirements create transparency. The institutional means for assuring accountability and transparency differ from one country to the next.

The Need for Accountability and Transparency Today every central bank announces its policy actions almost immediately. However the extent of the statements that accompany the announcement and the willingness to answer questions vary. Central bank statements are far more informative today than they were in the early 1990s. Secrecy is now understood to damage both the policymakers and the economies they are trying to manage. Give everyone the same information at the same time.