Chapter 15
Central Banks in the World Today
Conceptual Problems
1. In 1900, there were 18 central banks in the world; today, there are about 185. Why does
nearly every country in the world now have a central bank? (LO1)
Answer: A central bank plays a vital role in any nation’s economy. By controlling the rate at
2. The power of a central bank is based on its monopoly over the issuance of currency.
among several central banks be better? Provide arguments both for and against. (LO1)
Answer: Competition could force central banks to become more efficient and would increase
3. Explain the costs of each of the following conditions, and explain who bears them. (LO1)
a. Interest-rate instability
b. Exchange-rate instability
c. Inflation
Answer:
a. Interest-rate instability makes output unstable. It also increases risk and therefore the risk
b. Exchange-rate instability makes the revenue from exports and the costs of imports
c. Inflation creates uncertainty, which reduces investment and hurts growth. When inflation
d. When growth is unstable, people are less sure about their future incomes and are less
associated with unstable growth increases the risk premium and makes borrowing more
costly. Lower levels of borrowing reduce investment and hurt future growth.
4. Provide arguments for and against the proposition that a central bank should be allowed to
set its own objectives. (LO2, LO3)
Answer: One could argue that a central bank should be able to set its own objectives so as to
5. A euro-area country that runs very large public deficits or shows a persistently high and
moral hazard. (LO4)
Answer: The violation of the provisions of the treaty by a euro-area country poses a moral
hazard problem for the ECB because, if the country defaults on the debt, the ECB would
run poor fiscal policies. Default risk premia that are persistently too low encourage
governments to take greater fiscal risks.
6. How do long terms of office for central bankers help overcome the problem of time
inconsistency in monetary policy? (LO4)
Answer: Long appointments allow central bankers to resist reneging on desirable long-run
7. What problems does a central bank face in a country with inefficient methods of tax
collection? (LO4)
Answer: If the government cannot efficiently collect tax revenues, it may pressure the central
8. The Maastricht Treaty, which established the European Central Bank, states that the
the ECB’s ability to maintain price stability? (LO3)
Answer: Because politicians are elected for short terms, they have an incentive to create
short run but leads to inflation in the long run.
9. Transparency is a key element of the monetary policy framework. (LO3)
a. Explain how transparency helps eliminate the problems that are created by central bank
independence.
and explain why the bank might publish such a document.
Answer:
a. Central bank independence takes significant power away from elected politicians and
makes central bankers more accountable, consistent with representative democracy.
b. In volatile, uncertain times, central bank transparency helps reduce uncertainties that
policy approaches to the public made policy more predictable and effective.
c. The U.K. Inflation Report describes current economic conditions and makes projections
commitment more credible and helps to anchor inflation expectations.
10. *While central bank transparency is widely accepted as a desirable, too much openness may
have disadvantages. Discuss what some of these drawbacks might be. (LO3)
Answer: Disclosing too much information may, in fact, obscure the key message the central
commitment to and credibility of the policy eventually agreed upon. Knowing that the
minutes of policymaking meetings will be made public might stifle open and productive
11. Which do you think would be more harmful to the economy – an inflation rate that averages
Answer: Inflation of 5 percent with a high standard deviation is likely to be more harmful to
12. Suppose the central bank in your country has price stability as its primary goal. Faced with a
wide-range of views, which choice would you recommend? (LO3)
Answer: In general, decision-making by committee is considered a better choice as it allows
is also more legitimate to entrust monetary policy decisions to a group rather than an
individual.
13. Suppose the president of a newly independent country asks you for advice in designing the
country’s new central bank. For each of the following design features, choose which one you
would recommend and briefly explain your choice: (LO3)
the government.
c. The central bank policymakers are appointed for periods of four years to coincide with
Answer:
a. You should choose irreversible central bank decisions as the priorities of the central bank
b. You should choose for the central bank to be free to control its own budget. Otherwise,
c. You should choose to elect central bank policymakers for long terms in office to enable
14. “A central bank should remain vague about the relative importance it places on its various
time.” Assess this statement in light of what you know about good central bank design.
(LO3)
Answer: This statement is inaccurate. In order for the central bank to be credible, it needs to
communicate clearly its policy goals and the trade-offs between them. This allows the public
challenge of time consistency.
15. *The long list of central bank goals includes the stability of interest rates and exchange rates.
You look on the central bank Web site and note that they have increased interest rates at
every one of their meetings over the last year. You read the financial press and see references
you reconcile this behavior with the central bank pursuing its objectives? (LO2)
Answer: This behavior is perfectly consistent with a monetary policy framework that
considers low and stable inflation as a more important objective than interest-rate and
16. Provide arguments for why you think the financial crisis of 2007-2009 did or did not
compromise the independence of the Federal Reserve. (LO3)
Answer: To argue that the Fed’s independence was compromised, you could point out that,
during the crisis, the Fed cooperated closely with the Treasury to restore financial stability
of the Fed that would compromise its independence.
To argue that the Fed’s independence has not been compromised (in the absence of any
legislative changes so far), you could point out that its actions in cooperating with Treasury
independence.
17. Suppose in an election year, the economy started to slow down. At the same time, clear signs
reelection react? (LO2)
Answer: In this case, the appropriate monetary policy is to tighten monetary policy,
increasing interest rates to curb the emerging inflationary pressures in pursuit of the long-run
increases in government spending or reductions in taxes.
18. Assuming that they could, which of the following governments do you think would be more
likely to pursue policies that would seriously hinder the central bank’s pursuit of low and
stable inflation? Explain your choice. (LO4)
a. A government that is considered highly creditworthy both at home and abroad in a
Answer: The government described in b) would more likely be tempted to force the central
bank to buy its bonds to finance increased spending. In a politically unstable country,
in circulation would lead to higher inflation in conflict with the central bank’s goal.
19. *Suppose the government is heavily in debt. Why might it be tempting for the fiscal
inflationary? (LO4)
Answer: In this case, the inflation would benefit the fiscal policymakers, as it would erode
repay debt.
20. “A central bank cannot operate effectively if it has negative net worth.” State whether you
agree or disagree with this statement and provide a rationale for your choice. (LO3, LO4)
Answer: A choice of “agree” could be supported by pointing to threats that are largely
threatened the central bank’s independence.
A choice of “disagree” could be supported by arguments that are economic in nature. For
example, because the central bank can issue liabilities regardless of its net worth – it will
with the wider government balance sheet.
21. Explain how the statement by the FOMC in 2012 that an annual inflation rate of 2 percent
over the long run is consistent with its mandate can help the Federal Reserve fulfill that
mandate? (LO2, LO3)
Answer: The Federal Reserve stating its objective explicitly can help anchor inflationary
expectations. A credible central bank will be expected to alter policy in the future to keep
helping the achieve the goal of price stability.
Data Exploration
1. According to Figure 15.1, New Zealand in the 1970s and 1980s combined high inflation with
than before? Download the data and compute the average and the standard deviation of
inflation for: (a) the period through 1989 and (b) the period from 1990 to the present. (LO1)
Answer: The data plot below confirms that inflation was higher and more variable prior to
Organization for Economic Co-operation and Development, Consumer Price Index: OECD Groups: All Items Non-Food and
Non-Energy for New Zealand© [CPGRLE01NZQ659N], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/CPGRLE01NZQ659N.
2. Financial stability is a goal of most central banks. Based on a graph showing the evolution of
euro-area crisis intensified in 2011-2012? (LO1)
Answer: (a) Prior to 2007, ECB assets rose steadily, reflecting tranquil economic conditions.
(b) Following the Lehman failure in 2008, central bank assets rose quickly as the ECB
injected liquidity into the banking system to counter financial market disruptions. (c)
result, its balance sheet expanded again after 2014, setting a new record in 2016.
European Central Bank, Central Bank Assets for Euro Area (11-19 Countries)© [ECBASSETS], retrieved from FRED, Federal
Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/ECBASSETS.
3. Interest rate stability is a common goal of central banks. When has the Federal Reserve been
CPIAUCSL). Are stable interest rates associated with high or low inflation? Why? (LO1)
Answer: Higher inflation prior to 1985 was associated with volatile interest rates. Why? The
first reason is that the goal of low, stable inflation is a higher policy priority than the goal of
changes the real interest rate that influences economic activity.
4. To what extent has the Federal Reserve “monetized” government debt? Plot since 1970 the
held by the Federal Reserve System (FRED code: FDHBFRBN). (LO3)
Answer: By examining the annual change in the gross federal debt, we are evaluating new
levels and also were large as a share of new federal debt.
* indicates more difficult problems