Teaching excellence for over 100 years ECON 1082 Monetary Policy 2013/2014 Topic 8: Central Banking I Dr. Mete Feridun

Teaching excellence for over 100 yearsTeaching excellence for over 100 years

ECON 1082 Monetary Policy

2013/2014

Topic 8: Central Banking I

Dr. Mete Feridun

Teaching excellence for over 100 years

What is a Central Bank?

• A Central Bank is an entity responsible for overseeing a nation’s banking system, acting as a lender of last resort, conducting monetary policy, and maintaining currency stability.

• The two oldest Central Banks are the Swedish Riksbank (1668) and the Bank of England (1694), though elements of Central Banking have been around since the introduction of fiat money by the Mongols in the 13th century.

• The Central Bank in the U.S., the Federal Reserve System, was not created until 1913 due to the fear of centralized power along with a distrust of moneyed interests halted earlier attempts at creating a central bank A series of bank failures, culminating in panic of 1907 overcame these fears and paved the way for the “Fed.”


Time Inconsistency Problem• Monetary policy is often crafted to produce a long-run outcome such as

price stability.

• However, the actions needed to achieve this long run goal may not be the best choices in the short run.

• Such policies are time-inconsistent, i.e. CB does not consistently follow the plan over time.

• Suppose CB wanted to pursue the long run goal of price stability. In the short run, it will be tempted to inflate the economy to boost economic output. Doing so jeopardizes the goal of long run price stability as people revise their expectations about the CB’s policy stance. Expected inflation rises, which causes wages and prices to rise in the long run


Hierarchical and Dual Mandates• In the long run, price stability and the other goals of monetary policy are

not mutually exclusive.

• Price stability will promote interest rate and exchange rate stability in the long run. However, short-run price stability will frequently conflict with these other goals of monetary policy.

• Faced with rapidly rising prices, CB would have to cut the money supply and raise interest rates

• Doing so increases short-run unemployment and creates volatility in financial markets though!


Advantages and disadvantages of Hierarchical and Dual Mandates

• Hierarchical mandate: reinforces the public’s belief in the central bank’s commitment to price stability. It gets around the time inconsistency problem by limiting the policies that the central bank can do. However, it can lead to the central bank targeting short-run price stability, leading to large fluctuations in output and employment.

• Dual mandate gives central banks the freedom to stabilize employment in the short run while still setting a long run policy target of price stability. However, the dual mandate is subject to the time inconsistency problem. If people believe that the central bank is always going to promote employment over price stability in the short run, they will revise their inflation expectations upward.


Should price stability take precedence over all others?

• In a hierarchical mandate, price stability is the first goal and any other policy objective may only be targeted so long as it doesn’t interfere with price stability. The ECB has a hierarchical mandate – it can pursue high levels of employment and economic growth as long as it doesn’t endanger price stability.

• In a dual mandate, the central bank can simultaneously pursue both price stability and other goals (usually low unemployment). These goals may conflict in the short run. The Fed operates under such a system, with the stated goals of maximum employment, stable prices, and moderate long-term interest rates. There is no stated order of preference amongst these goals.


Central Bank Independence• Monetary policymakers should be insulated from popular opinion and

political pressure

• “Delegating monetary policy to an agent whose preferences are more inflation averse than are society’s preferences serves as a commitment device that permits sustaining a lower rate of inflation than would otherwise be possible.”

• 3 measures of Central Bank Independence:

1. Instrument independence : CB is free to set any monetary policy instrument/variable

2. Goal independence: CB is free to set its own goals for monetary policy

3. Political independence: CB is able to conduct monetary policy without legislative influence


Operational vs. Management Independence

• Operational independence• CB has the independence to determine the best way of achieving its

policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence.

• Granting of independence to the Bank of England in 1997 was, in fact, the granting of operational independence

• Management independence• CB has the authority to run its own operations (appointing staff,

setting budgets, and so on.) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence.


Central Bank Independence around the World

• In most of the industrialized world, central bank independence from the political process is gaining ground as the way to organize monetary authorities

• Countries with the most independent central banks have the lowest average rates of inflation, i.e. there is a very strong negative correlation between central bank independence and inflation.

• It is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. However, some economists argue that while this is true, it is low inflation rates that are causing central banks to become independent


Should a Central Bank be independent?

• Certain economic decisions can only be made by experts, and that politicians (and voters) lack the intelligence or training to reach the same decisions.

• However, there is no economic consensus and even the mainstream economic view changes over time (from classical to Keynesianism and back again).

• Politicians cannot be trusted with the levers of monetary policy, for they will adjust interest rates to suit the electoral cycle or attempt to bribe voters with their own money.


Independence vs. Inflation


Case for Independence• Monetary policy is too important and technical to be determined by

politicians. An independent CB is insulated from the political pressures of re-election and other political manipulation - The government could amass large budget deficits then turn to the CB to pay off its debts .

• Independence helps to avoid “Political Business Cycle” and “Inflationary Bias” which suggest that monetary policy would follow a volatile pattern where it is inflationary during an election year (CB would lower interest rates to stimulate credit demand and economic activity) and contractionary afterwards.

• It is argued that elected politicians may not have the technical savvy to conduct monetary policy


Case Against Independence• Undemocratic and Unaccountable : in a democracy elected officials should

make public policy. Is it democratic to have monetary policy for the entire nation in the hands of an “elite” group responsible to no one?

• Difficult to coordinate fiscal and monetary policy: Close coordination between monetary and fiscal policy would achieve the most effective results. The best way to coordinate both types of policies would be to have them controlled by the same group.

• Lost benefits of active monetary policy in reducing unemployment and increasing output

• Independent central bankers will prioritize inflation too strongly, causing an inferior social outcome. This is the case with ECB.


Bank of England• Until 1997, it was one of the least independent central banks

(Chancellor of Exchequer controlled the interest rates)

• In 1997 it was given the authority to control interest rates by Gordon Brown. But it was not granted total instrument independence – government can overrule and set rates in “extreme economic circumstances”

• Has monetary policy independence as it is not a member of European Monetary Union. However, is not goal-independent than the Fed as its inflation target is set by set by the Chancellor of Exchequer

• From April 2013 the bank resumed the job it lost in 1997 to FSA of supervising and regulating individual banks. It has new powers to secure financial stability using “macroprudential” tools, such as varying capital requirements for banks over the business cycle.


The Fed

• The Fed was designed to operate independently of external pressures. Governors have long and non-renewable terms. The Fed is financed out of its own revenues rather than by legislative approval

• It has instrument and goal independence. However, In practice, the system has not been completely insulated from political pressures the Fed operates in a political arena, and is subject to political pressure by legislators.

• The Fed remains a creation of Congress, which can amend the Fed’s charter and powers or even abolish it entirely.

• The President can exercise pressure through his control over the membership of the Board of Governors.


European Central Bank

• Most independent in the world as Its charter cannot by changed by legislation; only by revision of the Maastricht Treaty

• As in the case of the Fed Members of the Executive Board have long terms and it determines own budget

• Does not supervise and regulate financial institutions

• The ECB has less goal independence then the Fed as it has a mandate to promote price stability

• Each member state’s central bank operates much like the Regional Reserve Banks in the US do.


Thank you for your attention

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Teaching excellence for over 100 years ECON 1082 Monetary Policy 2013/2014 Topic 8: Central Banking I Dr. Mete Feridun