Chapter Fifteen
Central Banks in the World Today
Learning Objectives
Students will establish an understanding of 1. Functions and objectives of central banks.
2. Features of an effective central bank.
3. Fiscal challenges for central banks.
Introduction
• The world’s leading central banks played a key role in bringing the financial system and the economy back to safe harbor after the peak of the financial crisis in 2008.
• They acted in unprecedented fashion to
prevent the financial system from capsizing and, over time, to restore financial and
economic stability.
Introduction
• The central bank of the U.S. is the Federal Reserve (Fed).
• The people who work there are responsible for making sure that our financial system
functions smoothly so that the average citizen can carry on without worrying about it.
The Basics: How Central Banks Originated and Their Role Today
• The central bank started out as the
government’s bank and over the years added various other functions.
• A modern central bank not only
manages the government’s finances but provides an array of services to
commercial banks.
The Government’s Bank
• King William of Orange created the central bank to finance wars.
• Napoleon Bonaparte did it in an effort to
stabilize his country’s economic and financial system.
• These examples are more an exception because central banking is largely a 20th century phenomenon.
The Government’s Bank
• In 1900, only 18 countries had a central bank.
• The U.S. Federal Reserve began operation in 1914.
• As the importance of a government and the financial system grew, the need for a central bank grew along with it.
The Government’s Bank
• As the government’s bank, the central bank has a privileged position:
– It has the monopoly on the issuance of currency.
• The central bank creates money.
• Early central banks kept sufficient
reserves to redeem their notes in gold.
• Today, the Fed has the sole legal authority to issue U.S. dollar bills.
The Government’s Bank
• The central bank can control the availability of money and credit in a country's economy.
• Most central banks go about this by adjusting short-term interest rates: monetary policy.
– They use it to stabilize economic growth and information.
The Government’s Bank
Why would a country want to have its own monetary policy?
1. At its most basic level, printing money is a very profitable business.
– A bill only costs a few cents to print.
2. Government officials also know that losing control of the printing presses means losing control of inflation.
– A high rate of money growth creates a high inflation rate.
• Counterfeiting has been used as a weapon in wartime.
– The goal was to destabilize the enemy’s currency.
• Without a stable currency it is difficult for an economy to run efficiently.
• This is why preserving the value of a nation’s currency is one of the central bank’s most
important responsibilities.
The Banker’s Bank
• The political backing of the government, together with their sizeable gold reserve, made early central banks the biggest and most reliable banks around.
– The notes issued by the central bank were viewed as safer than those of smaller banks.
• The safety and convenience quickly persuaded most other banks to hold deposits at the central bank as well.
The Banker’s Bank
• As the banker’s bank, the central bank took on key roles it plays today:
1. To provide loans during times of financial stress, 2. To manage the payments system, and
3. To oversee commercial banks and the financial system.
• The ability to create money means that the central bank can make loans even when no one else can.
The Banker’s Bank
• Every country needs a secure and efficient payments system.
– Financial institutions need a cheap and reliable way to transfer funds to one another.
• The fact that all banks have account at the central bank makes the it the natural place for interbank payments to be settled.
• In 2002, an average of more than $2.4
trillion per day was transferred over Fedwire.
The Banker’s Bank
• Finally, someone has to watch over
commercial banks and nonbank financial
institutions so that savers and investors can be confident these institutions are sound.
• Those who monitor the financial system must have sensitive information.
• Government examiners and supervisors are the only ones who can handle such
information without conflict of interest.
The Banker’s Bank
• As the government’s bank and the banker’s bank, central banks are the biggest, most
powerful players in a country’s financial and economic system.
• However, an institution with the power to ensure that the economic and financial
systems run smoothly also has the power to create problems.
The Banker’s Bank
• It is essential that we understand what a central bank is not.
• It does not control securities markets,
though it may monitor and participate in bond and stock markets.
• It 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.
The Functions of a Modern
Central Bank
Stability: The Primary Objective of All Central Banks
• What makes the private sector incapable of doing what we have entrusted to the
government?
– In the cases of pollution and national defense, the answer is more obvious.
• Government involvement is justified by the presence of externalities or public goods.
• Economic and financial systems, when left on their own, are prone to episodes of
extreme volatility.
Stability: The Primary Objective of All Central Banks
We can easily see examples of failure:
1. The Great Depression of the 1930’s when the banking system collapsed.
– Economic historians state that the Fed failed to provide adequate money and credit.
2. The crisis of 2007-2009
– The Fed was largely passive as intermediaries took on increasing risk amid the housing bubble.
– It also allowed the crisis to intensify for more than a year after it had begun.
Stability: The Primary Objective of All Central Banks
Central bankers work to reduce the volatility of the economic and financial systems by
pursuing five specific objectives:
1. Low and stable inflation.
2. High and stable real growth, together with high employment.
3. Stable financial market and institutions.
4. Stable interest rates.
5. A stable exchange rate.
Stability: The Primary Objective of All Central Banks
• The job of the central bank is to improve general economic welfare by managing and reducing systematic risk.
• Instability in any of these five objectives poses a systematic or economy-wide risk.
• Understand that it is probably impossible to achieve all five of their objectives
simultaneously.
– Tradeoffs must be made.
Low, Stable Inflation
• Many central banks take their primary job as the maintenance of price stability.
– They strive to eliminate inflation.
– The consensus is that when inflation rises, the central bank is at fault.
• The purchasing power of one dollar, one yen, or one euro should remain stable over long periods of time.
• Maintaining price stability enhances money’s usefulness both as a unit of account and as a store of value.
Low, Stable Inflation
• Prices provide the information individuals and firms need to ensure that resources are
allocated to their most productive uses.
• But volatile inflation degrades the information content of prices.
• If the economy is to run efficiently, we need to be able to tell the reason why prices are
changing.
Low, Stable Inflation
• The higher inflation is, the less predictable it is, and the more systematic risk it creates.
• High inflation is also bad for growth.
• In cases of hyperinflation,
– Prices contain virtually no information, and
– People use all their energy just coping with the crisis so growth plummets.
Low, Stable Inflation
• Most people agree that low inflation should be the primary objective of monetary policy.
• How low should inflation be?
• Zero is probably too low.
– There would be a risk of deflation.
• This makes debts more difficult to repay,
increasing default, affecting the health of banks.
Low, Stable Inflation
• Zero inflation would also be difficult for companies.
– If an employer wished to cut labor costs, it would need to cut nominal wages which is difficult to do.
• So, a small amount of inflation makes labor markets work better, at least from an
employer’s point of view.
• High inflation is more volatile than low inflation.
• Volatile inflation means more risk which requires compensation.
• High inflation means a higher risk premium, so loan rates are higher.
• Volatile inflation makes long-term planning even more difficult.
High & Stable Real Growth
• To foster maximum sustainable growth in output and employment was one of Chairman Bernanke’s goals.
– This means working to dampen the fluctuations of the business cycle.
• By adjusting interest rates, central
bankers work to moderate these cycles and stabilize growth and employment.
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 – Their usual working hours.
• Growth in these inputs leads to growth in potential output -- sustainable growth.
High & Stable Real Growth
• A period of above-average growth has to be followed by a period of below-average growth.
• The job of the central bank during such periods is to change interest rates to adjust growth.
• In the long run, stability leads to higher growth.
– The greater the uncertainty about future business conditions, the more cautious people will be in making investments of all kinds.
High & Stable Real Growth
• Our hope is that policymakers can manage the country’s affairs so that we will stay on a high and sustainable growth path.
• Fluctuations in general business conditions are the primary source of systematic risk, so stability is important.
• Uncertainty about the future make
planning more difficult, so less uncertainty makes everyone better off.
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.
• Given the recent crisis, we know that
financial and economic catastrophes are not limited to the history books.
• Accordingly, financial system stability is an integral part of every modern central
banker’s job.
Financial System Stability
• If people lose faith in financial institutions and markets, they will rush to low-risk alternatives.
– Intermediation will stop.
• The possibility of a severe disruption in the financial markets is a type of systematic risk.
– Central banks must control this risk.
• The value at risk is the important measure here.
– This measures the risk of the maximum potential loss of a specific intermediary.
Financial System Stability
• Newer measure of risk seek to to quantify the impact that losses at an individual
intermediary could have on the stability of the financial system as a whole.
Interest-Rate and Exchange- Rate Stability
• 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.
Interest-Rate and Exchange- Rate Stability
Why is interest-rate volatility a problem?
1. Most people respond to low interest rates by borrowing and spending more and vice versa.
– Interest-rate volatility makes output unstable.
2. Interest-rate volatility means higher risk and therefore a higher risk premium.
– Risk makes financial decisions more difficult,
Interest-Rate an 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 dollar 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.
Central Bank Objectives:
Summary
• During the crisis, central banks had to co- operate with ministries of finance
• Many actions in the Euro-area crisis involved both fiscal and monetary policy action
• In Euro-Area sovereign debt crisis, sovereign and banks made deadly embrace
• If profligate fiscal policy as in Greece between 2000 and 2010, then sovereign debt is
downgraded, and cost of funding for banks rises because banks tend to hold domestic sovereign bonds on their balance sheets and use these bonds as collateral to secure liquidity (repo transactions with central bank)
• Higher cost of funding generates credit crunch which further deteriorates fiscal balance
leading to further downgrades
• Extreme example: Cyprus in June 2012
• Sovereign debt “junk” by all four CRAs
• Emergency Liquidity Assistance (ELA) needed as repos not allowed with “junk” bonds
• ELA implies higher funding cost and flags problems in financial system to outside observers
• Importance of maintaining stable and good sovereign debt ratings
• Therefore, responsible fiscal policy can help
Meeting the Challenge: Creating a Successful Central Bank
• In the past several decades, overall economic conditions improved nearly everywhere.
– This was especially true in rapidly growing
emerging economics such as Brazil, China and India.
• Virtually across the globe inflation was lower and more stable than in the 1980s.
• What explains this long period of stability?
Meeting the Challenge: Creating a Successful Central Bank
• A prime candidate is that technology sparked a boom just as central banks became better at their jobs.
1. Monetary policymakers realized that sustainable growth had gone up, so they could keep interest rates low without worrying about inflation.
2. Central banks were redesigned.
• Many believe that improvements in
economic performance after the 1980s were related at least in part to the policy followed by these restructured central banks.
Meeting the Challenge: Creating a Successful Central Bank
• Today economists are exploring how to improve financial regulation, and
reconsidering the role that central banks should play in financial supervision.
• To be successful, a central bank must:
1. Be independent of political pressure, 2. Make decisions by committee,
3. Be accountable to the public and transparent in communicating its policy actions, and
4. Operate within an explicit framework that clearly
The Need for Independence
• The idea of central bank independence, that central banks should be independent of
political pressure, is a new one.
• After all, the central bank originated as the government's bank.
The Need for Independence
Independence has two operational components.
1. Monetary policymakers must be free to control their own budgets.
2. The bank’s 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
• Successful monetary policy requires a long time horizon.
– The temptation to forsake long-term goals for
short-term gains is impossible for most politicians to resist.
• Knowing these tendencies, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution.
The Need for Independence
• The Fed’s extraordinary actions during the crisis of 2007-2009 led to political backlash in the U.S. against central bank
independence.
• The lingering political question is whether Congress will choose to sacrifice the hard- won gains on the inflation front by
weakening central bank independence.
– It would be another costly legacy of the financial
What drove politicians to give up control over
monetary policy?
Realization that
independent central bankers would deliver lower inflation than they themselves could.
Decision Making by Committee
• Monetary policy decisions are made
deliberately, after significant amounts of information are collected and examined.
• Crises do occur, requiring someone to be in charge.
• During normal operations, however, it is better to rely on a committee than an individual.
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
• Central bank independence is inconsistent with representative democracy.
• How can we have faith in our financial system if there are no checks on what the central bankers are doing?
• Proponents of central bank
independence had a twofold solution.
The Need for Accountability and Transparency
1. Politicians would establish a set of goals.
2. The policymakers would 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
The Need for Accountability and Transparency
• The economy and financial markets should respond to information that everyone received, not to speculation about what policymakers are doing.
– Policy makers need to be as clear as possible.
• Transparency can help counter the uncertainties and anxieties that feed liquidity and deleveraging spirals.
The Policy Framework, Policy Trade-offs, and Credibility
• To meet these objectives, central bankers must be independent, accountable, and good communicators.
• These qualities make up what we call the monetary policy framework.
– This exists to resolve ambiguities that arise in the course of the central bank’s work.
– Officials have told us what they are going to do.
– This helps people plan and keeps officials
The Policy Framework, Policy Trade-offs, and Credibility
• The monetary policy framework also clarifies the likely responses when goals conflict with one another.
• All objectives cannot be reached at the same time, and the Fed only has one instrument.
– It is impossible to use a single instrument to achieve a long list of objectives.
• The goal of keeping inflation low and stable, then, can be inconsistent with the goal of
The Policy Framework, Policy Trade-offs, and Credibility
• Central bankers face the trade-off
between inflation and growth on a daily basis.
– In 2008 the FOMC judged that it was more
important to cut the policy rate in an effort to halt the financial contagion that has resulted form the run on Bear Stearns.
– Policymakers were forced to choose among competing objectives amid great uncertainty.
The Policy Framework, Policy Trade-offs, and Credibility
• Because policy goals often conflict, central bankers must make their priorities clear.
• The public needs to know:
– What policymakers are focusing on and what they are willing to allow to change, and
– The roles that interest-rate and exchange-rate stability play in policy deliberations.
• This limits the discretionary authority of the central bankers, ensuring that they will do the job with which they have been entrusted.
The Policy Framework, Policy Trade-offs, and Credibility
• Finally, a well designed policy framework helps policy makers establish credibility.
– For central bankers to achieve their
objectives, everyone must trust them to do what they say they are going to do.
• Expected inflation creates inflation.
– Successful monetary policy, then, requires that inflation expectations be kept under control.
Central Bank Design:
Summary
Fitting Everything Together:
Central Banks and Fiscal Policy
• Before a European country can join the
common currency area and adopt the euro it is supposed to meet a number of conditions.
– The country’s annual budget deficit cannot exceed 3% of GDP, and
– The government’s total debt cannot exceed 60% of GDP.
• Failure to maintain these standards is supposed to lead to pressure from other member
countries and even to substantial penalties.
Fitting Everything Together:
Central Banks and Fiscal Policy
• By specifying a range of “acceptable” levels of borrowing, Europeans are trying to
restrict the fiscal policies that member countries enact.
– For the European Central Bank to do its job effectively, all the member countries’
governments must behave responsibly.
• Funding needs create a natural conflict
between monetary and fiscal policy makers.
Fitting Everything Together:
Central Banks and Fiscal Policy
• Central bankers, in their effort to stabilize prices and provide the foundation for high sustainable growth, take a long-term view.
– They impose limits on how fast the quantity of money and credit can grow.
• In contrast, fiscal policymakers tend to
ignore the long-term inflationary effects of their actions.
– They look for ways to spend resources today at
Fitting Everything Together:
Central Banks and Fiscal Policy
• Some fiscal policymakers resort to actions intended to get around restrictions imposed by the central bank.
– This erodes what is otherwise an effective and responsible monetary policy.
• Today the central bank’s autonomy leaves fiscal policymakers with two options for financing government spending.
– Take a share of income and wealth through taxes.
– Borrow by issuing bonds in the financial markets.
Fitting Everything Together:
Central Banks and Fiscal Policy
• If officials can’t raise taxes and are having trouble borrowing, inflation is the only way out.
• While central bankers hate it, inflation is a real temptation to shortsighted fiscal
policymakers.
• Inflation is a way for governments to
default on a portion of the debt they owe.
Fitting Everything Together:
Central Banks and Fiscal Policy
• U.S. Fiscal and monetary policies to combat the crisis of 2007-2009 have led many
observers to worry both about future inflation risks and about renewed financial instability.
– On the fiscal side, in 2009, the federal
government’s deficit surpassed 10% of GDP for the first time since WWII, and remained above 7%
even in 2012.
– On the monetary policy side, the Fed accumulated assets at an unprecedented pace as it sought to
Fitting Everything Together:
Central Banks and Fiscal Policy
• Both these policies must be reversed to prevent a large future inflation.
• When faced with a fiscal crisis, politicians often look for the easiest way out.
– If that way is inflating the value of the currency today, they will worry about the consequences tomorrow.
• Monetary policy can meet its objective of price stability only if the government lives within its budget and never forces the
Fitting Everything Together:
Central Banks and Fiscal Policy
• Responsible fiscal policy is essential to the success of monetary policy.
• There is no way for a poorly designed central bank to stabilize prices, output, the financial system, and
interest and exchange rates, regardless of the government’s behavior.
• To be successful, a central bank must be independent, accountable, and clear about its goals.
• It must also have a well-articulated communications strategy and a sound decision-making mechanism.
• In Japan the new government is imposing a new inflation target on the Bank of Japan and changing their leadership to one that supports the new government's fiscal regime.
• This is not just political dominance, but fiscal dominance.
• There is also some early signs of this in the use of the ECB to finance cross-border
financial support organization in the Eurozone.
• Many investors have concluded that this is now an inevitable trend in place that will over throw central bank independence in the developed world.
– That politicians will be able to expand fiscal policy and inflate away the burden of public debt.
• However, although this is what is happening in Japan, the rest of the developed world
seems to be moving in the other direction.
