© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 15

Central Banks in the World Today

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Central Banks:The Big Questions

1. What is the role of the central bank?

2. What are the central bank’s objectives?

3. How are successful central bank’s organized?

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Central Banks:Roadmap

• The origins and roles of central banks

• Central bank objectives

• Designing a successful central bank

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Central Banks:Origins and Roles

• There are about 170 central banks in the world today. Nearly every country has one.

• When the Soviet Union collapsed in 1990, the 12 of the 15 republics had central banks within a year

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Central Banks:Origins and Roles

• Special type of financial intermediary

• Origin:– To provide for government finance– Originally private institutions

• Roles– Government’s bank– Banker’s bank

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Central Banks:The Government’s Bank

• Manage the finances of the government

• Central banks create money They print currency

• Control availability of money and credit

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• Counterfeiting has been used as a weapon in wartime

• Goal to destabilize enemy’s currency

• Without a stable currency it is difficult for an economy to run efficiently

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Central Banks:The Bankers’ Bank

• Operate interbank payments network

• Provide loans during periods of crisis

• Oversee financial intermediaries to insure safety and soundness

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Functions of a Modern Central Bank

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Central Bank Objectives:Stability

• Low and stable inflation

• High and stable growth

• Stable financial markets

• Interest-rate stability

• Exchange-rate stability

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Central Bank Objectives:Low & Stable Inflation

• Strive to eliminate inflationA dollar should always be worth a dollar– Prices are central to a market economy

Allocating resources to their best uses

– Inflation makes it more difficult to tell – High inflation is less predictable

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• High inflation is volatile inflation

• Volatile inflation means more risk

• Risk requires compensation

• High inflation means a higher risk premium, so higher loan rates

• Volatile inflation makes long-term planning difficult

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Central Bank Objectives:High & Stable Real Growth

• Support maximum sustainable growth

• Stable countries grow faster– Unstable growth creates risk– Unstable growth drives up interest rates– Higher interest rates me lower borrowing– Less borrowing means less investment– Less investment means less growth

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Central Bank Objectives:Financial System Stability

• When the financial system collapses, everything else goes with it.

• Can’t get car loans or mortgages

• Banks cease to operate properly

(Application of value-at-risk)

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Central Bank Objectives: Interest-Rate Stability

• Stable interest rates make economic decisions easier

• Stable short-term interest rates reduce risk premium on long-term interest rates

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Central Bank Objectives: Exchange-Rate Stability

• The more open an economy, the more important it is

• Makes cost of imports and revenue from exports more predictable

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Central Bank Objectives:Summary

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• Fed controls short-term interest rate

• News about future short-term interest rate affects long-term interest rates

• When long-term interest rates change, so do car loan and mortgage rates

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Designing a Successful Central Bank

• Independence

• Decision-making Framework

• Accountability, Transparency and Communication

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Central Bank Design:Independence

• Central banks need to be independent of political pressure

• Politicians have an incentive to create short-term prosperity at the expense of inflation tomorrow.

• Longer time horizon needed to avoid “inflation bias”

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Independent Central Banks Deliver Low Inflation

What drove politicians to give up control over monetary policy?

Realization that independent central bankers would deliver low inflation.

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Central Bank Design:Decision-Making Framework

• Should policy be made by an individual or by a committee?Committees provide safeguards against

putting the wrong person in charge

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Central Bank Design: Accountability, Transparency and Communication

• Central Bank Independence is inconsistent with representative democracy

• Solution:– Give central bankers clear objectives– Force them to tell us what they are doing

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Central Bank Design:Policy Tradeoffs

• Can’t always have everything at once– Sometimes the economy is hit by a shock

that drives inflation and growth in opposite directions

– Creates a tradeoff– Central bankers must be honest about the

fact that goals are sometimes in conflict

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Central Bank Design:Summary

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Central Banksand Fiscal Policy

• In emerging market countries like Brazil and Argentina, fiscal policy problems can make it impossible for central bankers to keep inflation low

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Central Banksand Fiscal Policy

• Fiscal authorities have 3 sources of funds– Taxes– Borrowing– Money printing

• The first 2 work only up to some limit• If the budget is unsustainable, force

money printing

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Central Banks and Fiscal Policy:Argentina in 2002

• Financial collapse tied to the regional government’s issuance of their own currency

• Made it so that the Central Bank of Argentina was helpless

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Web Links

Federal Reserve SystemBank of EnglandEuropean Central BankBank of Japan (English)Reserve Bank of AustraliaReserve Bank of New ZealandBank of Canada (English)Banco de Mexico (English)

© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 15

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