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Money & Banking ­ MGT411
VU
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.
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Money & Banking ­ MGT411
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Figure: Inflation and Central Bank Independence 1973-1988
9
Spain
8
United Kingdom
ˇ
ˇ
Denmark
7
ˇItaly
ˇ
ˇ
ˇ
6
New Zealand
Australia
ˇ
5
France/Norway
ˇ
United States
4
Japan
ˇ
Canada
Switzerland
Belgium
3
ˇNetherlands
ˇ
Germany
ˇ
ˇ
2
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.
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Money & Banking ­ MGT411
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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:
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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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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY