LOW, STABLE INFLATION:High, Stable Real Growth

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

MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK >>

Money & Banking MGT411

Lesson 31

LOW, STABLE INFLATION

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

eliminate inflation.

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.

High, Stable Real Growth

Central bankers work to dampen the fluctuations of the business cycle; booms are popular but

recessions are not.

Central bankers work to moderate these cycles and stabilize growth and employment by

adjusting interest rates.

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

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

Along with growth and employment, stability is also important, because fluctuations in general

business conditions are the primary source of systematic risk.

Financial System Stability

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

The possibility of a severe disruption in the financial markets is a type of systematic risk that

central banks must control.

Interest Rate and Exchange Rate Stability

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.

Money & Banking MGT411

Interest rate volatility is a problem because:

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

it means higher risk and a higher risk premium and makes financial decisions more difficult.

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.

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.

The objectives of a Modern Central Bank

Inflation creates confusion and makes planning difficult. When

Low Stable Inflation

inflation is high, growth is low

Stable predictable growth is higher than unstable, unpredictable

High Stable growth

growth

A stable financial system is necessity for an economy to operate

Financial System

efficiently

Stability

Interest rate volatility creates risk for both lenders and borrowers

Stable Interest Rates

Stable Exchange Rates Variable exchange rates make the revenues from foreign sales and the

cost of purchasing imported goods hard to predict

Meeting the Challenge: Creating a Successful Central Bank

The boom in the past decade with its associated decrease in volatility may have happened

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

Policymakers realized that sustainable growth had gone up, so interest rates could be kept low

without worrying about inflation, and central banks were redesigned.

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

policymakers to do.

A central bank must be

Independent of political pressure,

Accountable to the public,

Transparent in its policy actions,

Clear in its communications with financial markets and the public

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