© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 15 Central Banks in the World Today

15-2 Central Banks: The Big Questions 1.What is the role of the central bank? 2.What are the central bank’s objectives? 3.How are successful central bank’s organized?

15-3 Central Banks: Roadmap The origins and roles of central banks Central bank objectives Designing a successful central bank

15-4 Central Banks: Origins and Roles There are about 170 central banks in the world today. Nearly every country has one. When the Soviet Union collapsed in 1990, the 12 of the 15 republics had central banks within a year

15-5 Central Banks: Origins and Roles Special type of financial intermediary Origin: –To provide for government finance –Originally private institutions Roles –Government’s bank –Banker’s bank

15-6 Central Banks: The Government’s Bank Manage the finances of the government Central banks create money They print currency Control availability of money and credit

15-7 Counterfeiting has been used as a weapon in wartime Goal to destabilize enemy’s currency Without a stable currency it is difficult for an economy to run efficiently

15-8 Central Banks: The Bankers’ Bank Operate interbank payments network Provide loans during periods of crisis Oversee financial intermediaries to insure safety and soundness

15-9 Functions of a Modern Central Bank

15-10 Central Bank Objectives: Stability Low and stable inflation High and stable growth Stable financial markets Interest-rate stability Exchange-rate stability

15-11 Central Bank Objectives: Low & Stable Inflation Strive to eliminate inflation A dollar should always be worth a dollar –Prices are central to a market economy Allocating resources to their best uses –Inflation makes it more difficult to tell –High inflation is less predictable

15-12 High inflation is volatile inflation Volatile inflation means more risk Risk requires compensation High inflation means a higher risk premium, so higher loan rates Volatile inflation makes long-term planning difficult

15-13 Central Bank Objectives: High & Stable Real Growth Support maximum sustainable growth Stable countries grow faster –Unstable growth creates risk –Unstable growth drives up interest rates –Higher interest rates me lower borrowing –Less borrowing means less investment –Less investment means less growth

15-14 Central Bank Objectives: Financial System Stability When the financial system collapses, everything else goes with it. Can’t get car loans or mortgages Banks cease to operate properly (Application of value-at-risk)

15-15 Central Bank Objectives: Interest-Rate Stability Stable interest rates make economic decisions easier Stable short-term interest rates reduce risk premium on long-term interest rates

15-16 Central Bank Objectives: Exchange-Rate Stability The more open an economy, the more important it is Makes cost of imports and revenue from exports more predictable

15-17 Central Bank Objectives: Summary

15-18 Fed controls short-term interest rate News about future short-term interest rate affects long-term interest rates When long-term interest rates change, so do car loan and mortgage rates

15-19 Designing a Successful Central Bank Independence Decision-making Framework Accountability, Transparency and Communication

15-20 Central Bank Design: Independence Central banks need to be independent of political pressure Politicians have an incentive to create short-term prosperity at the expense of inflation tomorrow. Longer time horizon needed to avoid “inflation bias”

15-21 Independent Central Banks Deliver Low Inflation What drove politicians to give up control over monetary policy? Realization that independent central bankers would deliver low inflation.

15-22 Central Bank Design: Decision-Making Framework Should policy be made by an individual or by a committee? Committees provide safeguards against putting the wrong person in charge

15-23 Central Bank Design: Accountability, Transparency and Communication Central Bank Independence is inconsistent with representative democracy Solution: –Give central bankers clear objectives –Force them to tell us what they are doing

15-24 Central Bank Design: Policy Tradeoffs Can’t always have everything at once –Sometimes the economy is hit by a shock that drives inflation and growth in opposite directions –Creates a tradeoff –Central bankers must be honest about the fact that goals are sometimes in conflict

15-25 Central Bank Design: Summary

15-26 Central Banks and Fiscal Policy In emerging market countries like Brazil and Argentina, fiscal policy problems can make it impossible for central bankers to keep inflation low

15-27 Central Banks and Fiscal Policy Fiscal authorities have 3 sources of funds –Taxes –Borrowing –Money printing The first 2 work only up to some limit If the budget is unsustainable, force money printing

15-28 Central Banks and Fiscal Policy: Argentina in 2002 Financial collapse tied to the regional government’s issuance of their own currency Made it so that the Central Bank of Argentina was helpless

15-29 Web Links

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 15 End of Chapter