THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation

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Money & Banking MGT411

Lesson 30

THE GOVERNMENT'S BANK

The central bank started out as the government's bank, originally created by rulers to finance

wars

However, the early examples are really the exceptions, as central banking is largely a 20th

century phenomenon.

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

The central bank creates money and thereby controls the availability of money and credit in a

country's economy

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

monetary policy.

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

An expansionary or accommodative policy (lower interest rates) raises growth and inflation;

tighter or restrictive policy reduces them.

Governments want to control the printing of money because it is a very profitable business;

also, losing control of the amount of currency means losing control of inflation.

The Bankers' Bank

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

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

Manage the payments system (settles interbank payments).

Oversee commercial banks and the financial system (handles the sensitive information about

institutions without conflicts of interest).

By ensuring that sound banks and financial intermediaries can continue to operate, the central

bank makes the whole financial system more stable.

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.

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

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

A central bank does not control:

Securities markets

The government's budget

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.

Stability: The Primary Objective of All Central Banks

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

Central bankers pursue five specific objectives:

Low and stable inflation

High and stable real growth, together with high employment

Stable financial markets

Stable interest rates

A stable exchange rate

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.

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

must be made

Low, Stable Inflation

Many central banks take as their primary job the maintenance of price stability; they strive to

eliminate inflation.

Money & Banking MGT411

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.

Inflation degrades the information content of prices and impedes the market's function of

allocating resources to their best uses.

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

Also, high inflation is bad for growth.

While there is agreement that low inflation should be the primary objective of monetary policy,

there is no agreement on how low inflation should be.

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.

Furthermore, if inflation were zero, an employer wishing to cut labor costs would need to cut

nominal wages, which is difficult to do.

A small amount of inflation may actually make labor markets work better, at least from the

employer's point of view.

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