MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK

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Money & Banking MGT411

Lesson 32

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.

In addition, there is general agreement

That policy decisions are better made by committee than by individuals,

That everyone is well served when policymakers operate within an explicit framework that

clearly states their goals and the tradeoffs among them.

The need for independence

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

central banks originated as the governments' banks.

Independence has two components:

Monetary policymakers must be free to control their own budgets

The bank's policies must not be reversible by people outside the central bank.

Successful monetary policy requires a long time horizon, which is inconsistent with the need of

politicians to focus on short-term goals.

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.

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.

Decision-Making by Committee

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

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.

The Need for Accountability and Transparency

Central bank independence is inconsistent with representative democracy.

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

to report their progress in pursuing these 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;

In some cases the government sets an explicit numerical target for inflation, while in others the

central bank defines the target.

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

Money & Banking MGT411

Figure: Inflation and Central Bank Independence 1973-1988

Spain

United Kingdom

Denmark

·Italy

New Zealand

Australia

France/Norway

United States

Japan

Canada

Switzerland

Belgium

·Netherlands

Germany

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Index of Central Bank Independence

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.

The Policy Framework, Policy Trade-offs, and Credibility

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.

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.

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

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

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

The Principles of Central Bank Design

To keep inflation low, monetary decisions must be made free of political

Independence

influence

Decision making by Pooling the knowledge of a number of people yields better decisions than

decision making by an individual

committee

Accountability and Policy makers must be held accountable to the public they serve and

clearly communicate their objectives, decisions and methods

transparency

Politicians must clearly state their policy goals and the tradeoffs among

Policy framework

them

Fitting Everything Together:

Central Banks and Fiscal Policy

The central bank does not control the government's budget; fiscal policy (the decisions about

taxes and spending) is the responsibility of elected officials

While fiscal and monetary policymakers share the same ultimate goal of improving the well-

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

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

Money & Banking MGT411

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

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.

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.

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

The Central Bank's Balance Sheet

The central bank engages in numerous financial transactions, all of which cause changes in its

balance sheet.

Central banks publish their balance sheets regularly. Publication is a crucial part of transparency

Table: The Central Bank's Balance Sheet

Assets

Liabilities

Securities

Currency

Government's bank

Foreign exchange reserves

Government's account

Loans

Accounts of the commercial banks

Banker's bank

(reserves)

Assets

The central bank's balance sheet shows three basic assets:

Securities,

Foreign exchange reserves,

Loans

Securities:

The primary assets of most central banks;

Independent central banks determine the quantity of securities that they purchase

Foreign Exchange Reserves:

The central bank's and government's balances of foreign currency are held as bonds issued by

foreign governments.

These reserves are used in foreign exchange market interventions.

Loans are extended to commercial banks, and can fall into two categories: discount loans and

float

Discount loans: the loans the central bank makes when commercial banks need short-term cash.

Float: a byproduct of the central bank's check-clearing business. The central bank credits the

reserve account of the bank receiving the check before it debits the account of the bank on

which the check was drawn and this creates float

Through its holdings of Treasury securities the central bank controls the discount rate and the

availability of money and credit.

Gold reserves, while still an asset of many central banks, are virtually irrelevant these days.

Liabilities

There are three major liabilities:

Currency,

The government's deposit account,

The deposit accounts of the commercial banks.

The first two items represent the central bank in its role as the government's bank, and the third

shows it as the bankers' bank.

Currency:

Nearly all central banks have a monopoly on the issuance of currency, and currency accounts

for over 90 percent of the central bank's liabilities.

Government's account:

100

Money & Banking MGT411

The central bank provides the government with an account into which it deposits funds

(primarily tax revenues) and from which it writes checks and makes payments.

Reserves:

Commercial bank reserves consist of cash in the bank's own vault and deposits at the central

bank, which function like the commercial bank's checking account.

Central banks run their monetary policy operations through changes in banking system reserves.

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