Money and Banking Lecture 30

Review of the Previous Lecture Banking Crisis Sources of Runs, Panics and Crisis Government Safety Net Government as lender of last resort

Topics under Discussion Central Bank: The Government’s Bank The Bankers’ Bank Objectives

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The Government's Bank The central bank started out as the government’s bank, originally created by rulers to finance wars However, the early examples are really the exceptions, as central banking is largely a 20th century phenomenon. The central bank occupies a privileged position: it has a monopoly on the issuance of currency

The central bank creates money and thereby controls the availability of money and credit in a country’s economy Most central banks go about this by adjusting short-term interest rates, an activity called monetary policy. In today’s world, central banks use monetary policy to stabilize economic growth and inflation.

An expansionary or accommodative policy (lower interest rates) raises growth and inflation; tighter or restrictive policy reduces them. Governments want to control the printing of money because it is a very profitable business; also, losing control of the amount of currency means losing control of inflation.

The Bankers' Bank The most important day-to-day jobs of the central bank are to: provide loans during times of financial stress (the lender of last resort). manage the payments system (settles interbank payments). oversee commercial banks and the financial system (handles the sensitive information about institutions without conflicts of interest).

By ensuring that sound banks and financial intermediaries can continue to operate, the central bank makes the whole financial system more stable. Central banks are the biggest and most powerful players in a country’s financial and economic system and are supposed to use this power to stabilize the economy, making us all better off.

A central bank does not control : However, central banks that are under extreme political pressure, or that are simply incompetent, can wreak havoc on the economic and financial systems. A central bank does not control : securities markets. the government’s budget.

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

The Functions of a Modern Central Bank The Government’s Bank A: Manages the finances of the Govt. B: Controls the availability of money and credit through interest rates The Bankers’ Bank A: Guarantees that sound banks can do business by lending to them even during crisis B: Operates a payment system for interbank payments C: Oversees financial institutions to ensure confidence in their soundness

Stability: The Primary Objective of All Central Banks When economic and financial systems are left on their own they are prone to episodes of extreme volatility; central bankers work to reduce that volatility Central bankers pursue five specific objectives: low and stable inflation high and stable real growth, together with high employment stable financial markets stable interest rates a stable exchange rate

Instability in any of those would pose an economy-wide economic risk that diversification could not mitigate. Thus the job of the central bank is to improve general economic welfare by managing and reducing systematic risk. It is probably impossible to achieve all five of these objectives simultaneously, and so tradeoffs must be made

Low, Stable Inflation Many central banks take as their primary job the maintenance of price stability; they strive to eliminate inflation. The rationale for keeping the economy inflation-free is that money’s usefulness as a unit of account and as a store of value is enhanced when its purchasing power is maintained.

Inflation degrades the information content of prices and impedes the market’s function of allocating resources to their best uses. The higher the inflation is, the less predictable it is, and the more systematic risk it creates. Also, high inflation is bad for growth.

While there is agreement that low inflation should be the primary objective of monetary policy, there is no agreement on how low inflation should be. Zero inflation is too low, because it brings the risk of deflation (a drop in prices) which in turn results in increased defaults on loans and a threat to the health of banks.

Furthermore, if inflation were zero, an employer wishing to cut labor costs would need to cut nominal wages, which is difficult to do. A small amount of inflation may actually make labor markets work better, at least from the employer’s point of view.