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Stephen G. CECCHETTI Kermit L.SCHOENHOLTZ
Central Banks in the World Today
Copyri ght 2011 by The McGraw-H il l Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin
Chapter Fifteen
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Introduction
The worlds leading central banks played a key
role in bringing the financial system and the
economy back to safe harbor after the peak of
the financial crisis in 2008.
They acted in unprecedented fashion to prevent
the financial system from capsizing and, over
time, to restore financial and economic
stability.
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Introduction
The central bankof the U.S. is the FederalReserve (Fed).
The people who work there are responsible for
making sure that our financial system functionssmoothly so that the average citizen can carry
on without worrying about it.
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Introduction
In Part IV, we will study the evolving role ofcentral banks.
Central banks do not act only during times of crisis.
Their work is vital to the day-to-day operation ofany modern economy.
Today there are roughly 170 central banks in the
world.
Most people only have a vague idea of what centralbanks do.
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Introduction
This chapter begins to explain the role of central banksin our economic and financial system.
It will describe the origins of modern central banking.
It will examine the complexities policymakers now
face in meeting their responsibilities.
It will highlight a central question that has become
politically controversial: what is the proper
relationship between a central bank and the
government?
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The Basics: How Central Banks
Originated and Their Role Today
The central bank started out as thegovernments bank and over the years added
various other functions.
A modern central bank not only manages thegovernments finances but provides an array of
services to commercial banks.
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The Governments Bank
King William of Orange created the centralbank to finance wars.
Napoleon Bonaparte did it in an effort to
stabilize his countrys economic and financialsystem.
These examples are more an exception because
central banking is largely a 20th century
phenomenon.
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The Governments Bank
In 1900, only 18 countries had a central bank.
The U.S. Federal Reserve began operation in
1914.
As the importance of a government and thefinancial system grew, the need for a central
bank grew along with it.
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The Governments Bank
As the governments bank, the central bank hasa privileged position:
It has the monopoly on the issuance of currency.
The central bank creates money. Early central banks kept sufficient reserves to
redeem their notes in gold.
Today, the Fed has the sole legal authority to
issue U.S. dollar bills.
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The Governments Bank
The central bank can control the availability ofmoney and credit in a country's economy.
Most central banks go about this by adjusting
short-term interest rates: monetary policy. They use it to stabilize economic growth and
information.
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The Governments Bank
Why would a country want to have its ownmonetary policy?
1. At its most basic level, printing money is a very
profitable business.
A bill only costs a few cents to print.
2. Government officials also know that losing control
of the printing presses means losing control of
inflation.
A high rate of money growth creates a high
inflation rate.
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The Governments Bank
The primary reason for a country to create itsown central bank, then, is to ensure controlover its currency. Giving the currency-printing monopoly to someone
else could be disastrous. In the European Monetary Union, 16 European
countries have ceded their right to conductindependent monetary policy to the European
Central Bank (ECB). This was part of a broader move toward economic
integration.
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Counterfeiting has been used as a weapon inwartime.
The goal was to destabilize the enemys currency.
Without a stable currency it is difficult for aneconomy to run efficiently.
This is why preserving the value of a nations
currency is one of the central banks most
important responsibilities.
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The Bankers Bank
The political backing of the government,together with their sizeable gold reserve, made
early central banks the biggest and most
reliable banks around.
The notes issued by the central bank were viewed as
safer than those of smaller banks.
The safety and convenience quickly persuaded
most other banks to hold deposits at the centralbank as well.
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The Bankers Bank
As the bankers bank, the central bank tookon the roles it plays today:1. To provide loans during times of financial stress,
2. To manage the payments system, and
3. To oversee commercial banks and the financialsystem.
The ability to create money means that thecentral bank can make loans even when no
one else can.
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The Bankers Bank
No bank, no matter how well managed, canwithstand a run.
To stave off such a crisis, the central bank can
lend reserves or currency to sounds banks. By ensuring that sound banks and financial
institutions can continue to operate, the central
bank makes the whole financial system more
stable.
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The Bankers Bank
Every country needs a secure and efficientpayments system.
Financial institutions need a cheap and reliable way
to transfer funds to one another.
The fact that all banks have account at the
central bank makes the it the natural place for
interbank payments to be settled.
In 2009, an average of more than $2.5 trillionper day was transferred over Fedwire.
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The Bankers Bank
Finally, someone has to watch overcommercial banks and nonbank financialinstitutions so that savers and investors can beconfident these institutions are sound.
Those who monitor the financial system musthave sensitive information.
Government examiners and supervisors are theonly ones who can handle such information
without conflict of interest.
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The Bankers Bank
As the governments bank and the bankersbank, central banks are the biggest, most
powerful players in a countrys financial and
economic system.
However, an institution with the power to
ensure that the economic and financial systems
run smoothly also has the power to create
problems.
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The Bankers Bank
It is essential that we understand what a centralbank is not.
It does not control securities markets, though it
may monitor and participate in bond and stockmarkets.
It does not control the governments budget.
That is determined by Congress and the president
through fiscal policy. The Fed only acts as the Treasurys bank.
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The Functions of a Modern
Central Bank
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Stability: The Primary Objective
of All Central Banks
What makes the private sector incapable ofdoing what we have entrusted to thegovernment? In the cases of pollution and national defense, the
answer is more obvious. Government involvement is justified by the
presence of externalities or public goods.
Economic and financial systems, when left on
their own, are prone to episodes of extremevolatility.
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Stability: The Primary Objective
of All Central Banks
We can easily see examples of failure:
1. The Great Depression of the 1930s when the
banking system collapsed.
Economic historians state that the Fed failed toprovide adequate money and credit.
2. The crisis of 2007-2009
The Fed was largely passive as intermediaries took
on increasing risk amid the housing bubble. It also allowed the crisis to intensify for more than
a year after it had begun.
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Stability: The Primary Objective
of All Central Banks
Central bankers work to reduce the volatilityof the economic and financial systems by
pursuing five specific objectives:
1. Low and stable inflation.
2. High and stable real growth, together with high
employment.
3. Stable financial market and institutions.
4. Stable interest rates.5. A stable exchange rate.
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Stability: The Primary Objective
of All Central Banks
It is important to realize that instability in anyof these poses an economy-wide risk that
individuals cant diversify away.
The job of the central bank is to improvegeneral economic welfare by managing and
reducing risk.
Understand that it is probably impossible to
achieve all five of their objectivessimultaneously.
Tradeoffs must be made.
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Low, Stable Inflation
Many central banks take their primary job asthe maintenance of price stability. They strive to eliminate inflation.
The consensus is that when inflation rises, the
central bank is at fault. The purchasing power of one dollar, one yen,
or one euro should remain stable over longperiods of time.
Maintaining price stability enhances moneysusefulness both as a unit of account and as astore of value.
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Low, Stable Inflation
Prices provide the information individuals andfirms need to ensure that resources are
allocated to their most productive uses.
But, inflation degrades the information contentof prices.
If the economy is to run efficiently, we need to
be able to tell the reason why prices are
changing.
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Low, Stable Inflation
The higher inflation is, the less predictable it is,and the more systematic risk it creates.
High inflation is also bad for growth.
In cases ofhyperinflation, when prices doubleevery two to three months,
Prices contain virtually no information, and
People use all their energy just coping with the
crisis so growth plummets.
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Low, Stable Inflation
Most people agree that low inflation should bethe primary objective of monetary policy.
How low should inflation be?
Zero is probably too low. There would be a risk of deflation.
This makes debts more difficult to repay,
increasing default, affecting the health of banks.
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Low, Stable Inflation
Zero inflation would also be difficult forcompanies.
If an employer wished to cut labor costs, it would
need to cut nominal wages which is difficult to do.
So, a small amount of inflation makes labor
markets work better, at least from an
employers point of view.
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High inflation is more volatile than lowinflation.
Volatile inflation means more risk which
requires compensation. High inflation means a higher risk premium, so
loan rates are higher.
Volatile inflation makes long-term planning
even more difficult.
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High & Stable Real Growth
To foster maximum sustainable growth inoutput and employment is one of Chairman
Bernankes goals.
This means he is working to dampen the
fluctuations of the business cycle.
By adjusting interest rates, central bankers
work to moderate these cycles and stabilize
growth and employment
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High & Stable Real Growth
The idea is that there is some long-runsustainable level of production calledpotential
output, which depends on things like
Technology,
The size of the capital stock, and
The number of people who can work.
Growth in these inputs leads to growth in
potential output-- sustainable growth.
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High & Stable Real Growth
A period of above-average growth has to befollowed by a period of below-average growth.
The job of the central bank during such periodsis to change interest rates to adjust growth.
In the long run, stability leads to highergrowth. The greater the uncertainty about future business
conditions, the more cautious people will be in
making investments of all kinds.
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High & Stable Real Growth
Our hope is that policymakers can manage thecountrys affairs so that we will stay on a high
and sustainable growth path.
Fluctuations in general business conditions arethe primary source of systematic risk, so
stability is important.
Uncertainty about the future make planning
more difficult, so less uncertainty makeseveryone better off.
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Financial System Stability
The Fed was founded to stop the financialpanics that plagued the U.S. during the late
19th and early 20th centuries.
Given the recent crisis, we know that financial
and economic catastrophes are not limited to
the history books.
Accordingly, financial system stability is an
integral part of every modern central bankersjob.
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Financial System Stability
If people lose faith in financial institutions andmarkets, they will rush to low-risk alternatives.
Intermediation will stop.
The possibility of a severe disruption in thefinancial markets is a type of systematic risk.
Central banks must control this risk.
The value at riskis the important measure here.
This measures the risk of the maximum potentialloss.
I t t R t E h R t
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Interest-Rate an Exchange-Rate
Stability
These goals are secondary to those of lowinflation, stable growth, and financial stability.
In the hierarchy, interest-rate stability and
exchange-rate stability are means for achieving
the ultimate goal of stabilizing the economy.
They are not ends unto themselves.
I t t R t E h R t
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Interest-Rate an Exchange-Rate
Stability
Why is interest-rate volatility a problem?1. Most people respond to low interest rates by
borrowing and spending more and vice versa.
Interest-rate volatility makes output unstable.2. Interest-rate volatility means higher risk and
therefore a higher risk premium.
Risk makes financial decisions more difficult,
lower productivity, and lessen efficiency.
I t t R t E h R t
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Interest-Rate an Exchange-Rate
Stability
The value of a countrys currency affects thecost of imports to domestic consumers and the
cost of exports to foreign buyers.
When the exchange rate is stable, the dollar
price of goods is predictable and planning
ahead is easier for everyone.
For emerging market countries, exports and
imports are central to the structure of theeconomy.
Stable exchange rates are very important.
C t l B k Obj ti
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Central Bank Objectives:
Summary
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During the crisis, did the Fed sacrifice itsmonetary policy independence and its objective
of low, stable inflation?
Many Fed actions in the crisis were radical and
precedent-setting.
Has the crisis made the Fed a slave of U.S.
government policy wishes?
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In a financial crisis, the policy goals may bemutually consistent.
An independent central bank may wish to
cooperate with fiscal authorities to promote
financial stability and forestall deflation.
An independent central bank must also be
prepared to reverse course when necessary to
keep inflation low. The difficulty is knowing when to exit.
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Likely the greatest threat to the Fedindependence is the popular backlash following
the crisis bailouts of intermediaries like AIG.
If heightened congressional scrutiny leads to
political efforts to influence future monetary
policy decisions, confidence in the Feds
commitment to low inflation could quickly
erode.
Meeting the Challenge: Creating
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Meeting the Challenge: Creating
a Successful Central Bank
In the past several decades, overall economicconditions improved nearly everywhere.
This was especially true in rapidly growing
emerging economics such as Brazil, China and
India.
Growth was higher, inflation was lower, and
both were more stable than in the 1980s.
What explains this long period of stability?
Meeting the Challenge: Creating
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Meeting the Challenge: Creating
a Successful Central Bank
A prime candidate is that technology sparkeda boom just as central banks became better attheir jobs.1. Monetary policymakers realized that sustainable
growth had gone up, so they could keep interestrates low without worrying about inflation.
2. Central banks were redesigned.
Many believe that improvements in economic
performance during the 1990s were related atleast in part to the policy followed by theserestructured central banks.
Meeting the Challenge: Creating
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Meeting the Challenge: Creating
a Successful Central Bank
Today economists are exploring how to improvefinancial regulation, and reconsidering the role that
central banks should play in financial supervision.
To be successful, a central bank must:
1. Be independent of political pressure,2. Make decisions by committee,
3. Be accountable to the public and transparent in
communicating its policy actions, and
4. Operate within an explicit framework that clearly states its
goals and makes clear the trade-offs among them.
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The Need for Independence
The idea ofcentral bank independence, thatcentral banks should be independent of
political pressure, is a new one.
After all, the central bank originated as the
government's bank.
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The Need for Independence
Independence has two operationalcomponents.
1. Monetary policymakers must be free to
control their own budgets.
2. The banks policies must not be reversible by
people outside the central bank.
The U.S. Federal Open Market Committees
decisions cannot be overridden by the President,Congress or the Supreme Court.
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The Need for Independence
Successful monetary policy requires a longtime horizon.
The temptation to forsake long-term goals for short-
term gains is impossible for most politicians to
resist.
Knowing these tendencies, governments have
moved responsibility for monetary policy into a
separate, largely apolitical, institution.
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The Need for Independence
The Feds extraordinary actions during thecrisis of 2007-2009 led to political backlash in
the U.S. against central bank independence.
The lingering political question is whether
Congress will choose to sacrifice the hard-won
gains on the inflation front by weakening
central bank independence.
It would be another costly legacy of the financialcrisis.
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What drove politicians to
give up control over
monetary policy?
Realization that independent
central bankers would
deliver lower inflation than
they themselves could.
Decision Making by
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Decision Making by
Committee
Monetary policy decisions are madedeliberately, after significant amounts of
information are collected and examined.
Crises do occur, requiring someone to be in
charge.
During normal operations, however, it is better
to rely on a committee than an individual.
Decision Making by
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Decision Making by
Committee
Pooling the knowledge, experience, andopinions of a group of people reduces the riskthat policy will be dictated by an individualsquirks.
Vesting so much power in one individual also posesa legitimacy problem.
Therefore, monetary policy decisions are madeby committee in all major central banks in the
world.
The Need for Accountability and
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The Need for Accountability and
Transparency
Central bank independence is inconsistent withrepresentative democracy.
How can we have faith in our financial system
if there are no checks on what the central
bankers are doing?
Proponents of central bank independence had a
twofold solution.
The Need for Accountability and
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The Need for Accountability and
Transparency
1. Politicians would establish a set of goals.2. The policymakers would publicly report their
progress in pursuing those goals.
Explicit goals fosteraccountability anddisclosure requirements create transparency.
The institutional means for assuring
accountability and transparency differ from
one country to the next.
The Need for Accountability and
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The Need for Accountability and
Transparency
Today every central bank announces its policyactions almost immediately.
However the extent of the statements that
accompany the announcement and the willingness
to answer questions vary.
Central bank statements are very different
today than they were in the early 1990s.
Secrecy is now understood to damage both the
policymakers and the economies they are trying to
manage.
The Need for Accountability and
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The Need for Accountability and
Transparency
The economy and financial markets shouldrespond to information that everyone received,
not to speculation about what policymakers are
doing.
Policy makers need to be as clear as possible.
Transparency can help counter the
uncertainties and anxieties that feed liquidity
and deleveraging spirals.
The Policy Framework Policy
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The Policy Framework, Policy
Trade-offs, and Credibility
To meet these objectives, central bankers mustbe independent, accountable, and good
communicators.
These qualities make up what we call the
monetary policy framework.
This exists to resolve ambiguities that arise in the
course of the central banks work.
Officials have told us what they are going to do. This helps people plan and keeps officials
accountable to the public.
The Policy Framework Policy
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The Policy Framework, Policy
Trade-offs, and Credibility
The monetary policy framework also clarifiesthe likely responses when goals conflict with
one another.
All objectives cannot be reached at the same
time, and the Fed only has one instrument.
It is impossible to use a single instrument to achieve
a long list of objectives.
The goal of keeping inflation low and stable,then, can be inconsistent with the goal of
avoiding a recession.
The Policy Framework Policy
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The Policy Framework, Policy
Trade-offs, and Credibility
Central bankers face the trade-off betweeninflation and growth on a daily basis.
In 2008 the FOMC judged that it was more
important to cut the policy rate in an effort to halt
the financial contagion that has resulted form therun on Bear Stearns.
Policymakers were forced to choose among
competing objectives amid great uncertainty.
The Policy Framework Policy
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The Policy Framework, Policy
Trade-offs, and Credibility
Because policy goals often conflict, centralbankers must make their priorities clear.
The public needs to know:
What policymakers are focusing on and what they
are willing to allow to change, and
The roles that interest-rate and exchange-rate
stability play in policy deliberations.
This limits the discretionary authority of thecentral bankers, ensuring that they will do the
job with which they have been entrusted.
The Policy Framework Policy
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The Policy Framework, Policy
Trade-offs, and Credibility
Finally, a well designed policy frameworkhelps policy makers establish credibility.
For central bankers to achieve their objectives,
everyone must trust them to do what they say they
are going to do.
Expected inflation creates inflation.
Successful monetary policy, then, requires that
inflation expectations be kept under control.
Central Bank Design:
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Central Bank Design:
Summary
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
Before a European country can join thecommon currency area and adopt the euro it is
supposed to meet a number of conditions.
The countrys annual budget deficit cannot exceed
3% of GDP, and
The governments total debt cannot exceed 60% of
GDP.
Failure to maintain these standards can lead to
pressure from other member countries and even
to substantial penalties.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
By specifying a range of acceptable levels ofborrowing, Europeans are trying to restrict the
fiscal policies that member countries enact.
For the European Central Bank to do its job
effectively, all the member countries governmentsmust behave responsibly.
Funding needs create a natural conflict between
monetary and fiscal policy makers.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
Central bankers, in their effort to stabilizeprices and provide the foundation for high
sustainable growth, take a long-term view.
They impose limits on how fast the quantity of
money and credit can grow.
In contrast, fiscal policymakers tend to ignore
the long-term inflationary effects of their
actions.
They look for ways to spend resources today at the
expense of prosperity tomorrow.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
Some fiscal policymakers resort to actionsintended to get around restrictions imposed by
the central bank.
This erodes what is otherwise an effective and
responsible monetary policy.
Today the central banks autonomy leaves
fiscal policymakers with two options for
financing government spending.
Take a share of income and wealth through taxes.
Borrow by issuing bonds in the financial markets.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
If officials cant raise taxes and are havingtrouble borrowing, inflation is the only way
out.
While central bankers hate it, inflation is a real
temptation to shortsighted fiscal policymakers.
Inflation is a way for governments to default
on a portion of the debt they owe.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
U.S. Fiscal and monetary policies to combatthe crisis of 2007-2009 have led many
observers to worry both about future inflation
risks and about renewed financial instability.
On the fiscal side, in 2009, the federal
governments deficit neared 10% of GDP for the
first time since WWII.
On the monetary policy side, the Fed accumulated
assets at an unprecedented pace as it sought toprevent a meltdown of the financial system.
Fitting Everything Together:
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Central Banks and Fiscal Policy
Both these policies must be reversed to preventa large future inflation.
When faced with a fiscal crisis, politiciansoften look for the easiest way out.
If that way is inflating the value of the currencytoday, they will worry about the consequencestomorrow.
Monetary policy can meet its objective of price
stability only if the government lives within itsbudget and never forces the central bank tofinance a fiscal deficit.
Fitting Everything Together:
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Fitting Everything Together:
Central Banks and Fiscal Policy
Responsible fiscal policy is essential to the success ofmonetary policy.
There is no way for a poorly designed central bank to
stabilize prices, output, the financial system, and
interest and exchange rates, regardless of thegovernments behavior.
To be successful, a central bank must be independent,
accountable, and clear about its goals.
It must also have a well-articulated communicationsstrategy and a sound decision-making mechanism.
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Popular fury over the crisis bailouts of largefinancial firms fueled a congressional attack on
Fed independence.
As of early 2010, it remains unclear whether
Congress will enact legislation that weakens the Fedor adds to its supervisory responsibilities.
Regulatory reforms that aim to strengthen the
financial system can have troublesome
unintended consequences.
Stephen G CECCHETTI Kermit L SCHOENHOLTZ
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Stephen G. CECCHETTI Kermit L.SCHOENHOLTZ
Central Banks in the World Today
End of
Chapter Fifteen