978-1259285295 Chapter 15 Lecture Note

Unlock access to all the studying documents.

View Full Document

Chapter 15 – Central Banks in the World Today

Chapter 15

Central Banks in the World Today

Chapter Overview

Despite the constant presence of central banks in the news and their unprecedented power, most

people only have a vague idea of what they are and what they do. The purpose of this chapter is

to explain the role of modern central banks in our economic and financial system and to examine

the complexities policymakers face in meeting their responsibilities.

Learning Objectives: Understand…

1. Functions and objectives of central banks

2. Features of an effective central bank

3. Fiscal challenges for central banks

Important Points of the Chapter

The Federal Reserve is the United States’ central bank, which has the responsibility of making

sure that our financial system functions smoothly. Central banks act during times of crisis, but

their work is also vital to the day-to-day operation of any modern economy.

Application of Core Principles

Principle #5: Stability. 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 by

pursuing the objectives of: low and stable inflation; high and stable real growth, together with

high employment; stable financial markets; stable interest rates; and a stable exchange rate.

Principle #2: Risk. Inflation creates risk, and the higher it is the greater the risk. Unpredictable

inflation makes bonds risky because it affects the real return a bondholder receives. Since the

risk has increased, so must the compensation, and thus inflation risk drives up the interest rate

required to entice investors to hold bonds.

Principle #2: Risk. Central bankers work to moderate fluctuations in general business

conditions because they are the primary source of systematic risk.

Principle #5: Stability. The objectives of a modern central bank are all about stability, in

inflation, growth, the financial system, interest rates and exchange rates.

Principle #3: Information. Central bank statements are very different today than they were at the

beginning of the 1990s, because secrecy is now understood to damage both the policymakers and

the economies they are trying to manage.

15-1

Education.

Chapter 15 – Central Banks in the World Today

Teaching Tips/Student Stumbling Blocks

If you have the equipment to do so, one of the most effective ways to begin the material

in this chapter is to visit the web site of the Bank for International Settlements. In

particular, a list of central banks and links to their web pages can be found at

http://www.bis.org/cbanks.htm. This certainly reinforces the point about how many

countries have central banks.

An interesting assignment might be to have students pick different countries and write a

short comparison of its central bank to the Federal Reserve System. This will be a good

lead-in to the material in the next chapter that compares the Fed to the European Central

Bank (and for that reason you may wish to exclude those countries from the possible

choices).

Features in this Chapter

Applying the Concept: Why Is Stable Money Such a Big Deal?

In 1940 the Germans under Adolf Hitler used slave labor to manufacture counterfeit British

pounds; about 150,000,000 British pounds worth of bogus notes of different denominations. The

objective was to introduce the fake currency into Britain and thereby undermine public

confidence in the currency and damage the British economy. Called “Operation Bernhard,” this

Nazi attempt to use counterfeiting as a weapon of war is neither unique nor unprecedented.

However it does point out the indispensable role of a stable and reliable monetary standard in

modern economies.

Your Financial World: Why Inflation Is Bad for You

Most people would say that inflation is bad because it reduces what they can buy with their

incomes. Economists see inflation differently; to them, inflation creates risk and the higher it is

the greater the risk. Unpredictable inflation makes bonds risky because it affects the real return a

bondholder receives. Since the risk has increased, so must the compensation, and thus inflation

risk drives up the interest rate required to entice investors to hold bonds. In addition, interest

rates on mortgages are also increased, and inflation makes it harder for people to know how

much to save for retirement.

Lessons from the Crisis: Threats to Fed Independence

During the financial crisis of 2007-2009, the Fed and the Treasury cooperated closely with the

Fed appearing to act as an agent of the Treasury. Some question whether the Fed sacrificed its

monetary independence and its objective of low, stable inflation. Others point out that the policy

goals of financial stability, stable growth, and stable prices are mutually consistent and that a

responsive Fed is appropriate. A responsive Fed, however, must be willing to change course as

necessary to keep inflation low.

15-2

Education.

Chapter 15 – Central Banks in the World Today

Applying the Concept: Independent Central Banks Deliver Lower Inflation

Independent central banks can deliver lower inflation than politicians can, because the more

control the politicians have over the central bank the more money they are likely to create in

order to relieve short-term fiscal problems.

In the News: The Politicisation (or Not) of Central Banks

Political dominance over central banks is causing debate. Political dominance occurs when

elected politicians force central bankers to take actions they would not choose to take if they

made the decisions. This dominance is occurring in Japan and is beginning to appear in the

ECB. Many economists believe that greater political control is inevitable for two main reasons.

First, central banks are operating outside the boundaries of traditional monetary policy. Second,

the relationship between fiscal and monetary policy encourages cooperation between the two.

Lessons of the Article: When its interest-rate target is at zero, a central bank may welcome

fiscal stimulus to promote economic stability. The inflationary danger arises if a central

bank acquiesces to government pressure to purchase (monetize) its debt. Such pressures

usually rise with the cost of issuing securities to the public, but—as of early 2013—

government bond yields remained extremely low in most advanced economies.

Additional Teaching Tools

Have a class sing along! Before the Fed announced a rate increase on June 30, 2004, the Federal

Reserve Bank of Cleveland had posted on its web site the June issue of its publication Economic,

which included a parody of a famous song by Bob Dylan. To be sung to the tune of “The Times

They Are A-changin’”:

The Rates They Are A-changin’

(with apologies to Bob Dylan)

Come gather ’round people wherever you roam

Recognize that inflation around you has grown

And accept there’s a chance it could rise through its zone

Price stability is worth preservin’

So less stimulus from the Fed don’t bemoan

For the rates they are a-changin’.

Come writers and critics who prophesize with your pens

Who are so confident in your opinions

But don’t speak too soon for the data still spins

And there’s no tellin’ where it is goin’

The theories out now could later be in

For the rates they are a-changin’.

Come savers, investors, please heed the call

15-3

Education.

Chapter 15 – Central Banks in the World Today

The signs are well-posted and the writin’s on the wall

Inflation dynamics no longer are stalled

For markets are equilibratin’.

And many have said that the funds rate’s too small

For the rates they are a-changin’.

Thank goodness most people throughout the land

No longer criticize for they quite understand

Reputation requires that you protect your brand

When patience so plainly is wanin’

So stay with the program while the Fed plays its hand

For the rates they are a-changin’.

The line it is drawn, the course nearly cast

The risks we face now appeared small in the past

But with measured steps the expansion will last

Futures markets are anticipatin’

A considerable time will be comin’ to pass

For the rates they are a-changin’.

The Cleveland Fed added a disclaimer:

“These lyrics are a Dylanesque take on the current situation; they are not an official statement

about the likely course of monetary policy.”

Do an internet search on “Parsing Fed Statement.” Note how many different sources “parse”

each statement of the Federal Reserve.

Virtual Tools

Go to http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm to see the Federal Open

Market Committee meeting schedule and released statements from previous meetings.

Visit the European Central Bank on the web at:

http://www.ecb.int/home/html/index.en.html

Here’s a web site, called the Bank for International settlements, which provides links to all the

central banks of the world: http://www.bis.org/cbanks.htm

For More Discussion

In this video from Bloomburg Business Week

(http://www.businessweek.com/videos/2013-12-09/blackrocks-fisher-on-central-banks-strategy),

Peter Fisher, former U.S. Treasury undersecretary for domestic finance considers domestic

central bank policy and investment strategy for 2014.

15-4

Education.

Chapter 15 – Central Banks in the World Today

Chapter Outline

I. The Basics: How Central Banks Originated and Their Role Today

A. The Government’s Bank

1. The central bank started out as the government’s bank, originally created by rulers to

finance wars.

2. However, the early examples are really the exceptions, as central banking is largely a

20th century phenomenon.

3. The central bank occupies a privileged position: it has a monopoly on the issuance of

currency.

4. The central bank creates money and thereby controls the availability of money and

credit in a country’s economy.

5. Most central banks go about this by adjusting short-term interest rates, an activity

called monetary policy.

6. In today’s world, central banks use monetary policy to stabilize economic growth and

inflation.

7. An expansionary or accommodative policy (lower interest rates) raises growth and

inflation; tighter or restrictive policy reduces them.

8. Governments want to control the printing of paper money because it is a very

profitable business; also, losing control of the amount of currency means losing

control of inflation.

B. The Bankers’ Bank

1. The most important day-to-day jobs of the central bank are to:

a. provide loans during times of financial stress (the lender of last resort).

b. manage the payments system (settles interbank payments).

c. oversee commercial banks and the financial system (handles the sensitive

information about institutions without conflicts of interest).

2. By ensuring that sound banks and financial intermediaries can continue to operate,

the central bank makes the whole financial system more stable.

3. 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.

4. However, central banks that are under extreme political pressure, or that are simply

incompetent, can wreak havoc on the economic and financial systems.

5. A central bank does not:

a. control securities markets.

b. control the government’s budget.

15-5

Education.

Chapter 15 – Central Banks in the World Today

6. 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.

II. Stability: The Primary Objective of All Central Banks

1. When left on their own economic and financial systems are prone to episodes of

extreme volatility; central bankers work to reduce that volatility.

2. Central bankers pursue five specific objectives:

a. low and stable inflation

b. high and stable real growth, together with high employment

c. stable financial markets and institutions

d. stable interest rates

e. a stable exchange rate

3. 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.

4. It is probably impossible to achieve all five of these objectives simultaneously, and so

tradeoffs must be made.

A. Low, Stable Inflation

1. Many central banks take as their primary job the maintenance of price stability; they

strive to eliminate inflation.

2. 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.

3. Inflation degrades the information content of prices and impedes the market’s

function of allocating resources to their best uses.

4. The higher inflation is, the less predictable it is, and the more systematic risk it

creates.

5. Also, high inflation is bad for growth.

6. While there is agreement that low inflation should be the primary objective of

monetary policy, there is no agreement on how low the inflation rate should be.

7. 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.

8. Furthermore, if the inflation rate were zero, an employer wishing to cut labor costs

would need to cut nominal wages, which is difficult to do.

9. A small amount of inflation may actually make labor markets work better, at least

from the employer’s point of view.

15-6

Education.

Chapter 15 – Central Banks in the World Today

B. High, Stable Real Growth

1. Central bankers work to dampen the fluctuations of the business cycle; booms are

popular but recessions are not.

2. Central bankers work to moderate these cycles and stabilize growth and employment

by adjusting interest rates.

3. Monetary policymakers can moderate recessions by lowering interest rates and can

moderate booms by raising them (to keep growth at a sustainable level).

4. Along with growth and employment, stability is also important, because fluctuations

in general business conditions and financial crises are the primary source of

systematic risk.

C. Financial System Stability

1. Financial system stability is an integral part of every modern central banker’s job.

2. The possibility of a severe disruption in the financial markets is a type of systematic

risk that central banks must control.

D. Interest Rate and Exchange Rate Stability

1. Interest rate stability and exchange rate stability are a means for achieving the

ultimate goal of stabilizing the economy; they are not ends unto themselves.

2. Interest rate volatility is a problem because:

a. it makes output unstable as borrowing and expenditure fluctuate with changing

rates.

b. it means higher risk and a higher risk premium and makes financial decisions

more difficult.

3. Even though the exchange rate affects the prices of imports and exports, stabilizing

exchange rates is the last item on the list of central bank objectives.

4. Different countries have different priorities when it comes to the exchange rate; stable

exchange rates are more important in developing countries because imports and

exports are central to their economies.

III. Meeting the Challenge: Creating a Successful Central Bank

1. The boom of the 1990s with its associated decrease in volatility may have happened

because technology sparked a boom just as central banks became better at their jobs.

2. Policymakers realized that sustainable growth had gone up, so interest rates could be

kept low without worrying about inflation, and central banks were redesigned.

3. Today there is a clear consensus about the best way to design a central bank and what

to tell policymakers to do.

4. A central bank must be independent of political pressure, accountable to the public,

transparent in its policy actions, and clear in its communications with financial

markets and the public.

15-7

Education.

Chapter 15 – Central Banks in the World Today

5. In addition, there is general agreement that policy decisions are better made by

committee than by individuals, and that everyone is well served when policymakers

operate within an explicit framework that clearly states their goals and the tradeoffs

among them.

A. The Need for Independence

1. The idea that central banks should be independent of political pressure is a new one,

because central banks originated as the governments’ banks.

2. Independence has two components: monetary policymakers must be free to control

their own budgets and the bank’s policies must not be reversible by people outside the

central bank.

3. Successful monetary policy requires a long time horizon, which is inconsistent with

the need of politicians to focus on short-term goals.

4. Given a choice, most politicians will choose monetary policies that are too

accommodative, keeping interest rates low and money growth rates high. While this

raises output and employment in the near term it may result in inflation over the

longer term.

5. To insulate policymakers from the daily pressures faced by politicians, governments

have given central banks control of their own budgets, authority to make irreversible

decisions, and appointed them to long terms.

B. Decision-Making by Committee

1. In the course of normal operations, it is better to rely on a committee than on an

individual.

2. Pooling the knowledge, experience, and opinions of a group of people reduces the

risk that policy will be dictated by an individual’s quirks, not to mention that in a

democracy, vesting so much power in one individual poses a legitimacy problem.

C. The Need for Accountability and Transparency

1. Central bank independence is inconsistent with representative democracy.

2. To solve this problem, politicians have established a set of goals and require the

policymakers to report their progress in pursuing these goals.

3. Explicit goals foster accountability and disclosure requirements create transparency.

4. The institutional means for assuring accountability and transparency differ from one

country to the next; in some cases the government sets an explicit numerical target for

inflation, while in others the central bank defines the target.

5. Similar differences exist in the timing and content of information made public by

central banks. Over time these differences have narrowed. Central bank statements

have much more information than they did in the early 1990s.

6. Today it is understood that secrecy damages both the policymakers and the economies

they are trying to manage, and that policymakers need to be as clear as possible about

what they are trying to achieve and how they are going to achieve it.

15-8

Education.

Chapter 15 – Central Banks in the World Today

D. The Policy Framework, Policy Trade-offs, and Credibility

1. The monetary policy framework is made up of the objectives of central banks and the

requirements that central banks be independent, accountable, and good

communicators.

2. The monetary policy framework exists to resolve the ambiguities that arise in the

course of the central bank’s work and also clarifies the likely responses when goals

are in conflict with one another.

3. Central bankers face the tradeoff between inflation and growth on a daily basis.

4. Since policy goals often conflict, central bankers must make their priorities clear.

5. A well-designed policy framework also helps policymakers establish credibility.

IV. Fitting Everything Together: Central Banks and Fiscal Policy

1. The central bank does not control the government’s budget; fiscal policy (the

decisions about taxes and spending) is the responsibility of elected officials.

2. While fiscal and monetary policymakers share the same ultimate goal of improving

the well-being of the population, conflicts can arise between the two.

3. Funding needs create a natural conflict between monetary and fiscal policymakers.

4. Fiscal policymakers also tend to ignore the long-term inflationary effects of their

actions.

5. Politicians often turn to borrowing (instead of taxes) as a way to finance some portion

of their spending, but a country can issue only so much debt.

6. Inflation is a real temptation to shortsighted fiscal policymakers because it is a way to

get money in their hands and it’s a way for governments to default on a portion of the

debt they owe.

7. The founders of the European Monetary Union wanted to ensure that participating

governments kept their fiscal houses in order (so that none of them would be tempted

to pressure the European Central Bank to create inflation and then bail them out) and

so they established criteria countries had to meet for inclusion.

8. Responsible fiscal policy is essential to the success of monetary policy.

15-9

Education.

Chapter 15 – Central Banks in the World Today

Terms Introduced in Chapter 15

accountability

central bank

central bank independence

credibility

financial system stability

fiscal policy

goal independence

hyperinflation

instrument independence

monetary policy

monetary policy framework

potential output

price stability

public goods

sustainable growth

transparency

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

US potential GDP GDPPOT

US real GDP GDPC1

US 10‐year Treasury yield GS10

US 10‐year Treasury inflation‐indexed yield FII10

US consumer price index CPIAUCSL

US consumer price index (less food and energy) CPILFESL

Personal consumption expenditures price index PCEPI

Personal consumption expenditures price index (less food and

energy)

PCEPILFE

Euro area harmonized index of consumer prices CP0000EZ17M086NEST

Euro area harmonized index of consumer prices (less unprocessed

food and energy)

00ZFUNEZ17M086NES

15-10

Education.

Chapter 15 – Central Banks in the World Today

Lessons of Chapter 15

1. The functions of a modern central bank are to

a. Adjust interest rates to control the quantity of money and credit in the economy.

b. Operate a payments system.

c. Lend to sound banks during times of stress.

d. Oversee the financial system.

2. The objective of a central bank is to reduce systematic risk in the economic and financial

system. Specific objectives include

a. Low and stable inflation.

b. High and stable growth and employment.

c. Stable financial markets and institutions.

d. Stable interest rates.

e. Stable exchange rates.

Because these objectives often conflict, policymakers must have clear priorities.

3. The best central banks

a. Are independent of political pressure.

b. Make decisions by committee rather than by an individual.

c. Are accountable to elected representatives and the public.

d. Communicate their objectives, actions, and policy deliberations clearly to the public.

e. Articulate clearly how they will act when their goals conflict.

f. Are credible in their efforts to meet their objectives.

4. Fiscal policy can make the central bank’s job impossible because

a. Politicians take a short-term view, ignoring the inflationary impact of their actions over

the long term.

b. Politicians are predisposed toward financing techniques that will create inflation.

c. Inflation not only provides immediate revenue; it reduces the value of the government’s

outstanding debt.

d. Responsible fiscal policy is a precondition for successful monetary policy.

e. Central banks remain independent at the pleasure of politicians.

15-11

Education.