Chapter 15: Chapter 15 Central Banks in the World Today


Central Banks: The Big Questions: Central Banks: The Big Questions What is the role of the central bank? What are central bank objectives? How are successful central bank’s organized?


Central Banks: Central Banks 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


Web Links: Web Links www.bis.org


Roles of Central Bank: Roles of Central Bank


Roles of Central Bank: Roles of Central Bank 2. 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). Oversee commercial banks and the financial system to ensure confidence in their soundness.


The Primary Objective of all Central Banks: The Primary Objective of all Central Banks low and stable inflation high and stable growth, with high employment stable financial markets interest rate stability exchange rate stability Conflicting goals implies trade-off


Central Bank Objectives: Low and Stable Inflation: Central Bank Objectives: Low and Stable Inflation Money’s usefulness as a store of value and a unit of account and is reduced by inflation. Everyone is a millionaire in Zimbabwe Annual rate of inflation is 1000% High rates of inflation are less predictable and bad for growth. *


Central Bank Objectives: Low and Stable Inflation: Central Bank Objectives: Low and Stable Inflation The higher inflation is, the less predictable it is – wider variation. Unpredictable inflation makes bonds risky. Remember nominal interest rate = real interest rate + expected inflation + risk premium. Risk requires compensation ( Inflation risk). Makes long-term planning difficult Home Mortgage Retirement planning.


US. Inflation: US. Inflation


How Low?: How Low? No agreement on how low inflation should be. Zero inflation is probably too low. - risk of deflation (a drop in prices) which in turn results in increased defaults on loans and a threat to the health of banks. No stated inflation target in the US.


Central Bank Objectives:High & Stable Real Growth: 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 mean lower borrowing Less borrowing means less investment Less investment means less growth


Economic Performance: Economic Performance


Financial System Stability:: Financial System Stability: Financial collapse of the 1930s. Fed’s actions under Greenspan 1987, 1997, 2001 Bernanke – August 2007 to date. Central banks want to minimize the risk of a disaster and keep the chance of maximum loss as small as possible. Value-at-Risk


Central Bank Objectives: Interest-Rate Stability: 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


Central Bank Objectives: Exchange-Rate Stability: 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


Principles of Central Bank Design: Principles of Central Bank Design Independence Decision-making by Committee Accountability, Transparency and Communication


Central Bank Design: Independence: Central Bank Design: Independence Independence: To keep inflation low, monetary decisions must be made free of political pressure. Financial independence Policies can not be reversed. FOMC policies can not be overridden. Political business cycle.


Central Bank Design: Independence: 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”


Central Bank Design: Decision-Making Framework: Central Bank Design: Decision-Making Framework Should policy be made by an individual or by a committee? Pooling the knowledge of a number of people yields better decisions than decision making by an individual.


Principles of Central Bank Design: Principles of Central Bank Design Transparency: Policymakers must clearly communicate their objectives, decisions, and methods to the public.


Principles of Central Bank Design: Principles of Central Bank Design Accountability: Policymakers must be held accountable to elected representatives and the public they serve. U.S. - Full Employment Act of 1946 ECB - price stability England – Explicit price targets


Principles of Central Bank Design: Principles of Central Bank Design Policy Framework: Policymakers must clearly state their policy goals and the tradeoffs among them. Priorities: Inflation? Full employment? Exchange rate? Sometimes conflicts among objectives


Central Banks and Fiscal Policy: Central Banks and Fiscal Policy While the ultimate goals of fiscal and monetary policy makers are the same – conflicts can arise. Fiscal policymakers tend to ignore the long-term inflationary effects of their actions. In the early days of central banking, a government that needed money told the bank to print it. Independent central banks leave fiscal policy makers with two options for financing government spending.


Central Banks and Fiscal Policy: Central Banks and Fiscal Policy Taxes are not popular and politicians not want to reduce spending in their districts. So politicians often turn to borrowing. Can only issue so much debt: So much the population can afford Future tax revenues will not cover payment At that point turn to central bank to finance spending.