Module 7
Central Banks Assignment
a. The Basics: How Central Banks Originated and Their Role Today
Governments have financial needs of their own. Some rulers, like King
William of Orange, created the central bank to finance wars. Others, like Napoléon
Bonaparte, did it in an effort to stabilize their country’s economic and financial
system. While central banks have been around since the late 1600s, these early
examples are really the exceptions, as central banking is largely a 20th-century
phenomenon. In 1900, only 18 countries had central banks. Even the U.S. Federal
Reserve did not begin operating until 1914.3 As the importance of the government
and the financial system grew, the need for a central bank grew along with it. Today it
is hard to imagine not having one. As the government’s bank, the central bank
occupies a privileged position: It has a monopoly on the issuance of currency. The
central bank creates money. Historically, central bank money has been seen as more
trustworthy than that issued by kings, queens, or emperors. Rulers have had a
tendency to default on their debts, rendering their currencies worthless. By contrast,
early central banks kept sufficient reserves to redeem their notes in gold.
People must have faith in money if they are to use it, and this faith is critical to
the functioning of a modern economy. Without confidence in the value and stability of
money, individuals and businesses would be reluctant to accept it in exchange for
goods and services. This trust in money is not something that occurs naturally; it is
cultivated and maintained through a combination of historical precedent, legal
frameworks, and institutional arrangements.
One of the most significant factors in fostering this trust is the role of central
banks. In the United States, the Federal Reserve plays a crucial role in ensuring the
stability and reliability of the U.S. dollar. Established in 1913 in response to a series
of financial panics, the Federal Reserve, or the Fed, was designed to provide the
country with a safe, flexible, and stable monetary and financial system. The Fed’s
responsibilities include regulating and supervising banks, conducting monetary policy,
and providing financial services to depository institutions, the U.S. government, and
foreign official institutions.
The Federal Reserve has the sole legal authority to issue U.S. dollar bills,
which means it controls the creation and distribution of the nation’s currency. This
centralization of currency issuance helps prevent counterfeiting and ensures that all
U.S. dollar bills are backed by the full faith and credit of the United States
government. The design and production of U.S. currency incorporate numerous
security features to deter counterfeiting, including watermarks, security threads, and
color-shifting ink. These measures, combined with the legal authority of the Federal
Reserve, help maintain the integrity and trustworthiness of the U.S. dollar.
Moreover, the Federal Reserve's role in conducting monetary policy is pivotal
in maintaining confidence in the U.S. dollar. Through its control of interest rates and
the money supply, the Fed aims to promote maximum employment, stable prices, and
moderate long-term interest rates. By adjusting the federal funds rate, which is the
interest rate at which banks lend to each other overnight, the Fed can influence
economic activity. Lowering the rate can stimulate borrowing and spending, while
raising it can help control inflation. The Fed also uses open market operations, such as
buying and selling government securities, to influence the amount of money in
circulation.
The transparency and accountability of the Federal Reserve's operations
further contribute to public confidence. The Fed regularly publishes reports, holds
press conferences, and provides detailed explanations of its policy decisions. This
openness helps the public understand the rationale behind monetary policy actions
and fosters trust in the institution. The Fed’s independence from political influence is
another critical factor. While the Fed operates within the framework of policies set by
the government, its decisions on monetary policy are made without direct political
pressure, allowing it to focus on long-term economic stability rather than short-term
political considerations.
Historical experience has also played a significant role in shaping public faith
in money. Over time, people have seen that money issued by a stable and credible
central authority retains its value and functions effectively as a medium of exchange,
a unit of account, and a store of value. Instances of hyperinflation, such as those seen
in Weimar Germany or more recently in Zimbabwe and Venezuela, highlight the
importance of sound monetary management. In these cases, the lack of confidence in
the currency led to its rapid devaluation, demonstrating the disastrous consequences
of a breakdown in trust.
In addition to the central bank’s role, other institutional arrangements
contribute to maintaining faith in money. The legal tender laws, which require that
U.S. dollars be accepted for all debts, public and private, ensure that the currency is
widely used and accepted. The banking system, with its regulations and safeguards,
provides a stable environment for financial transactions. Deposit insurance, provided
by the Federal Deposit Insurance Corporation (FDIC), protects depositors' funds in
the event of a bank failure, further reinforcing confidence in the financial system.
Internationally, the U.S. dollar’s status as the world’s primary reserve currency
underscores its reliability. Many countries hold significant reserves of U.S. dollars and
use them in international trade and finance. This widespread acceptance and use of the
U.S. dollar on a global scale reflect the trust that foreign governments, businesses, and
individuals place in its stability and value. The U.S. dollar’s role in global finance also
means that the Federal Reserve’s policies can have far-reaching implications,
affecting not just the U.S. economy but the world economy as well.
In conclusion, people must have faith in money if they are to use it, and this
faith is underpinned by a complex web of institutional arrangements and historical
experiences. The Federal Reserve’s sole legal authority to issue U.S. dollar bills, its
role in conducting monetary policy, and its efforts to maintain transparency and
independence are central to this trust. The combination of legal frameworks,
regulatory safeguards, and international acceptance all contribute to the enduring
confidence in the U.S. dollar, ensuring that it continues to function effectively as
money in both domestic and global contexts.
The ability to print currency means that the central bank can control the
availability of money and credit in a country’s economy. This activity is what we
usually refer to as monetary policy. In today’s world, central banks use monetary
policy to stabilize economic growth and inflation. An expansionary or accommodative
policy, through lower interest rates, raises both growth and inflation over the short
run, while tighter or restrictive policy reduces them. We will discuss the mechanics of
monetary policy in more detail. Understanding why a country would want to have its
own monetary policy is important. At its most basic level, printing paper money is a
very profitable business. A $100 bill costs less than 15 cents to print, but it can be
exchanged for $100 worth of goods and services. It is logical that governments would
want to maintain a monopoly on printing paper money and to use the revenue it
generates to benefit the general public. (Although, when we list the objectives of the
central bank later, profit maximization will not be one of them.)
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. Giving the currency-printing monopoly to someone else can be disastrous,
resulting in high inflation and damage to the economy’s ability to function smoothly.
(In fact, attempts to destabilize the value of a country’s currency through
counterfeiting have been used as a weapon in wars. See Applying the Concept: Why
Is Stable Money Such a Big Deal?) Nevertheless, some countries have done it. The
leading example is the euro area, whose member-states ceded the conduct of monetary
policy to the ECB as part of a broader move toward economic integration. To limit
inflation risks, they enshrined rules for the ECB in a treaty, helping to secure the
ECB’s credibility even amid crisis. We will see, however, that securing price stability
and the viability of the euro over the long run also requires sound management of the
euro area’s government budgets, debt, and banking systems.
The political backing of the government, together with their sizable gold
reserves, 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,
making it easier for holders to convert their deposits into cash. This safety and
convenience quickly persuaded most other banks to hold deposits at the central bank
as well. As the bankers’ bank, the central bank took on key roles it plays today. The
important day-to-day jobs of the central bank are to (1) provide loans during times of
financial stress, (2) manage the payments system, and (3) oversee commercial banks
and the financial system. The central bank’s ability to create money means that it can
make loans even when no one else can, including during a crisis. We discussed this
“lender of last resort”. For now, all we need to say is that by ensuring that sound
banks and financial institutions can continue to operate, the central bank makes the
whole financial system more stable. Many people believe this is the most important
function of any modern central bank.
Second, every country needs a secure and efficient payments system. People
require ways to pay each other, and financial institutions need a cheap and reliable
way to transfer funds to one another.5 The fact that all banks have accounts there
makes the central bank the natural place for these interbank payments to be settled. In
today’s world, interbank payments are extremely important. Look at the daily volume
on the Federal Reserve’s Fedwire system. In 2018, an average of more than $2.8
trillion per day was transferred over the Fedwire—nearly one-seventh of the annual
U.S. gross domestic product. Finally, as we saw in our discussion of banking
regulation, someone has to watch over commercial banks and nonbank financial
institutions so that savers and investors can be confident they are sound. Those who
monitor the financial system must have sensitive information. For example, they need
to know the exact methods institutions use to make lending and credit decisions.
Needless to say, such knowledge would be very useful to the institutions’ competitors.
Government examiners and supervisors are the only ones who can handle such
information without conflict of interest. In some countries they are housed in the
central bank, while in others they work in separate agencies.
As the government’s bank and the bankers’ bank, central banks are the biggest,
most powerful players in a country’s financial and economic system. Central bankers
are supposed to use this power to stabilize the economy, making us all better off. And
for the most part, that is what they do. But any institution with the power to ensure
that the economic and financial systems run smoothly also has the power to create
problems. By limiting its lending early in the financial crisis of 2007–2009, the Bank
of England may have contributed to the first depositor run on a major British bank in
more than a century. And following the breakup of the Soviet Union, the failure of the
Bank of Russia to exert any control over the expansion of money and credit led to a
very high inflation rate, while Russian economic activity in the 1990s was virtually
halved. Before we go on to examine the goals and objectives of central bankers in
detail, it is essential that we understand what a modern central bank is not.
First, a central bank does not control securities markets, though it may monitor
and participate in bond and stock markets. Second, the central bank does not control
the government’s budget. In the United States, the budget is determined by Congress
and the president through fiscal policy. The U.S. Treasury then administers the
government, managing the collection of funds through the tax system and writing
checks to pay for the government’s expenditures. The Fed acts only as the Treasury’s
bank, providing a place for money paid to the government to be deposited, making
good on the government’s checks, and helping to borrow funds when they are needed.
Not just in the United States but throughout the world, the common arrangement
today is for the central bank to serve the government in the same way that a
commercial bank serves a business or an individual.
The Treasury or finance ministry plays a crucial role in managing a country’s
fiscal policy, which involves decisions about government spending, taxation, and
borrowing. Fiscal policy is a primary tool used by the government to influence
economic conditions, stabilize the economy, and promote sustainable growth. The
ministry is responsible for creating the national budget, collecting taxes, disbursing
public funds, and managing public debt. These functions are essential for funding
public services, such as healthcare, education, and infrastructure, and for addressing
economic challenges, such as unemployment and inflation.
In developing the national budget, the Treasury or finance ministry must
consider the economic environment and set priorities that align with the government’s
economic goals. This includes estimating revenue from various sources, such as taxes,
fees, and investments, and allocating funds to different sectors and programs. The
ministry also monitors economic indicators, such as GDP growth, inflation rates, and
employment levels, to make informed decisions about fiscal policy adjustments.
During times of economic downturn, the ministry may implement expansionary fiscal
policies, such as increasing public spending or cutting taxes, to stimulate economic
activity and reduce unemployment. Conversely, during periods of economic growth,
the ministry might adopt contractionary fiscal policies to prevent overheating and
control inflation.
The central bank, on the other hand, offers a set of services that make effective
fiscal management possible. The central bank’s primary responsibilities include
conducting monetary policy, overseeing the financial system, and providing financial
services to the government, financial institutions, and the public. By controlling the
money supply and interest rates, the central bank can influence economic activity,
stabilize prices, and promote financial stability. This, in turn, supports the goals of
fiscal policy and helps create a stable economic environment.
One of the central bank’s key functions is to act as the government’s banker. It
manages the government’s accounts, processes payments, and handles the issuance
and redemption of government securities. When the Treasury or finance ministry
needs to borrow funds to finance budget deficits or public projects, the central bank
facilitates the issuance of government bonds and other debt instruments. It also
manages the government’s debt portfolio, ensuring that borrowing costs are
minimized and debt levels remain sustainable. This collaboration between the central
bank and the Treasury or finance ministry is essential for effective public debt
management and maintaining investor confidence in government securities.
Additionally, the central bank conducts monetary policy, which involves
controlling the supply of money and the level of interest rates in the economy. By
adjusting the monetary policy stance, the central bank can influence economic
conditions and support fiscal policy objectives. For example, during an economic
recession, the central bank might lower interest rates and increase the money supply
to encourage borrowing, investment, and consumption. These measures can
complement expansionary fiscal policies, such as increased public spending or tax
cuts, to stimulate economic growth and reduce unemployment. Conversely, during
periods of high inflation, the central bank might raise interest rates and tighten the
money supply to cool down economic activity and stabilize prices, aligning with
contractionary fiscal policies.
The central bank also plays a critical role in maintaining financial stability,
which is essential for effective fiscal management. It oversees the banking system and
other financial institutions, ensuring that they operate soundly and meet regulatory
standards. The central bank conducts regular stress tests and supervises banks to
identify and mitigate risks that could threaten financial stability. By maintaining a
stable and resilient financial system, the central bank helps create an environment
where fiscal policies can be implemented effectively. For instance, a stable financial
system ensures that credit flows smoothly to businesses and households, supporting
economic growth and the goals of fiscal policy.
Moreover, the central bank provides essential financial services, such as
payment and settlement systems, which facilitate smooth and efficient transactions in
the economy. These systems enable the government, businesses, and individuals to
transfer funds securely and efficiently, supporting economic activity and fiscal
operations. The central bank’s role in ensuring the reliability and efficiency of these
systems is crucial for the effective implementation of fiscal policy.
In times of financial crises or economic shocks, the central bank and the
Treasury or finance ministry often coordinate their actions to stabilize the economy.
For example, during the global financial crisis of 2008-2009, central banks around the
world, including the U.S. Federal Reserve and the European Central Bank,
implemented extraordinary monetary policy measures, such as lowering interest rates
to near-zero levels and engaging in large-scale asset purchases (quantitative easing).
These actions aimed to provide liquidity to the financial system, support economic
activity, and prevent a deeper recession. Simultaneously, governments implemented
fiscal stimulus packages, including increased public spending and tax cuts, to boost
demand and support recovery. The coordinated efforts of central banks and finance
ministries were crucial in mitigating the impact of the crisis and restoring economic
stability.
In conclusion, the Treasury or finance ministry is responsible for managing
fiscal policy, which involves decisions about government spending, taxation, and
borrowing. This management is critical for funding public services, stabilizing the
economy, and promoting sustainable growth. The central bank offers a set of services
that make effective fiscal management possible, including conducting monetary
policy, overseeing the financial system, and providing financial services to the
government and financial institutions. The collaboration between the central bank and
the Treasury or finance ministry is essential for achieving economic stability,
supporting fiscal policy objectives, and maintaining investor confidence. By working
together, these institutions play a vital role in managing the economy and ensuring its
long-term health and stability.
b. Stability: The Primary Objective of All Central Banks
The central bank is essentially part of the government.6 Whenever we see an
agency of the government involving itself in the economy, we need to ask why. What
makes individuals incapable of doing what we have entrusted to the government? In
the case of national defense and pollution regulation, the reasons are obvious. Most
people will not voluntarily contribute their resources to the army. Nor will they
spontaneously clean up their own air. To put it slightly differently, government
involvement is justified by the presence of externalities or public goods (those that the
public cannot be excluded from using and whose use does not limit use by others).
The rationale for the existence of a central bank is equally clear. While economic and
financial systems may be fairly stable most of the time, when left on their own they
are prone to episodes of extreme volatility. Prior to the advent of the Fed, the U.S.
financial system was extremely unstable. It was plagued by frequent panics. Even
with a central bank, these systems don’t necessarily work well.
The historical record is filled with examples of failure, like the Great
Depression of the 1930s, when the banking system collapsed, economic activity
plunged by one-third, and, at its worst, one-quarter of Americans were unemployed
for nearly a decade. Economic historians blame the Federal Reserve for the severity of
that episode. The claim is that monetary policymakers failed to provide adequate
money and credit, with the result that 10,000 of the country’s 25,000 banks,
accounting for 13 percent of all deposits, were closed. The Fed also bears
considerable responsibility for the crisis of 2007–2009. It was largely passive as
intermediaries took on increasing risk amid an unprecedented housing bubble, and it
allowed the financial hurricane to intensify for more than a year after the storms
began. Unlike the Great Depression, however, the Fed used all its emergency
authority in historically unprecedented ways to steady the financial system when the
crisis peaked in 2008. The Fed’s tenacity and flexibility helped promote a huge
recovery of financial conditions in 2009 and avoid a second Great Depression.
Similarly, increasingly aggressive liquidity provision by the ECB beginning in 2010
(and continuing as of 2016) was essential to sustaining euro-area banks in the face of
runs on several countries’ banking systems.
Several years ago, Federal Reserve Board chair Janet L. Yellen summarized
virtually every economist’s view when she said “inflation that is high, excessively
low, or unstable imposes significant costs on households and businesses.” 7 That is
why many central banks take as their primary job the maintenance of price stability.
As a practical matter, that means keeping inflation low and stable. The consensus is
that when inflation rises too high or falls too low, and remains there for an extended
period, the central bank is at fault. The rationale for seeking price stability is
straightforward. Standards, everyone agrees, should be standard. A pound should
always weigh a pound, a cup should always hold a cup, and a yard should always
measure a yard. Similarly, a dollar should always be worth a dollar. What is true for
physical weights and measures should be true for the unit of account as well. The
purchasing power of one dollar, one yen, or one euro should remain stable over long
periods. Maintaining price stability enhances money’s usefulness both as a unit of
account and as a store of value.
Prices are central to everything that happens in a market-based economy. They
provide the information individuals and firms need to ensure that resources are
allocated to their most productive uses. When a seller can raise the price of a product,
for example, that is supposed to signal that demand has increased, so producing more
is worthwhile. But volatile inflation degrades the information content of prices. When
all prices are rising together, understanding the reasons becomes difficult. Did
consumers decide they liked an item, shifting demand? Did the cost of producing the
item rise, shifting supply? Or was inflation responsible for the jump in price? If the
economy is to run efficiently, we need to be able to tell the difference. If the inflation
rate were predictable—say, 10 percent year in and year out—we might be able to
adjust, eventually. But unfortunately, as inflation rises, it becomes less stable. If our
best guess is that the rate of inflation will be 2 percent over the coming year, we can
be fairly certain that the result will be a price level increase of between 1 and 3
percent. But experience tells us that when we expect the inflation rate to be around 10
percent, we shouldn’t be surprised if it ends up anywhere between 8 and 12 percent.
The higher inflation is, the less predictable it is, and the more systematic risk it
creates.
Moreover, high inflation is bad for growth. This fact is obvious in extreme
cases, such as the one in Zimbabwe, where prices doubled every day in November
2008, resulting in the second-largest inflation on record.9 In such cases of
hyperinflation, prices contain virtually no information, and people use all their energy
just coping with the crisis, so growth plummets. The Zimbabwe economy shrank by
nearly 20Npercent the year inflation peaked. Only when Zimbabweans gave up using
the local currency in favor of the U.S. dollar (a process called dollarization) did the
economy begin to grow again.
Because low inflation is the basis for general economic prosperity, most
people agree that it should be the primary objective of monetary policy. But how low
should inflation be? Zero is probably too low. There are several reasons for this. First,
if the central bank tries to keep the inflation rate at zero, there is a risk of deflation—a
drop in prices. Deflation makes debts more difficult to repay, which increases the
default rate on loans, affecting the health of banks. Second, if the inflation rate were
zero, an employer wishing to cut labor costs would need to cut nominal wages, which
is difficult to do. With a small amount of inflation, the employer can simply leave
wages as they are, and workers’ real wages will fall. So a small amount of inflation
makes labor markets work better, at least from the employer’s point of view.
When Ben S. Bernanke was sworn in as the 14th chair of the Board of
Governors of the Federal Reserve System, he said, “Our mission, as set forth by the
Congress, is a critical one: to preserve price stability, to foster maximum sustainable
growth in output and employment, and to promote a stable and efficient financial
system that serves all Americans well and fairly.”10 We just discussed the first of
these; preserving price stability requires keeping inflation low and stable. And we will
look at financial stability in a moment. For now, let’s examine the second item on
Bernanke’s list: to foster maximum sustainable growth in output and employment.
When central bankers talk like this, what they mean is that they are working to
dampen the fluctuations of the business cycle. Booms are popular, but recessions are
not. In recessions, people get laid off and businesses fail. Without a steady income,
individuals struggle to make their auto, credit card, and mortgage payments.
Consumers pull back, hurting businesses that rely on them to buy products. Reduced
sales lead to more layoffs, and so on. The longer the downturn goes on, the worse it
gets.
By adjusting interest rates, central bankers work to moderate these cycles and
stabilize growth and employment. The idea is that there is some long-run normal level
of production called potential output that depends on things like technology, the size
of the capital stock, the number of people who can work, and their usual working
hours. Growth in these inputs leads to growth in potential output—sustainable growth.
In the United States, growth averages 2 to 3Npercent per year. Over the short run,
output may deviate from its potential level, and growth may deviate from its long-run
sustainable rate. In recessions, the economy stalls, incomes stagnate, and
unemployment rises. By lowering interest rates, monetary policymakers can moderate
such declines.11 Similarly, there are times when growth rises above sustainable rates,
and the economy overheats. These periods may seem to bring increased prosperity,
but because they don’t last forever, they are followed by reduced spending, lower
business investment, and layoffs. A period of above-average growth has to be
followed by a period of below-average growth. The job of the central bank during
such periods is to raise interest rates and keep the economy from operating at
unsustainable levels.
Importantly, in the long run, stability leads to higher growth. The reason is that
unstable growth creates risk for which investors need to be compensated in the form
of higher interest rates. With higher interest rates, businesses and households borrow
less, which means that they have fewer resources to spend. To understand how this
works, think about getting a loan to buy a car. The more certain you are that you will
have a good, steady job over the next few years, the larger the loan you will feel
comfortable taking on. If you are nervous that you might lose your job, you will be
cautious. What is true for you and your car loan is true for every person and every
company. The greater the uncertainty about future business conditions, the more
cautious people will be in spending. Stability leads to higher growth.12 The
importance of keeping sustainable growth as high as possible is hard to overstate. The
difference between an economy that grows at 4 percent per year and one that grows at
2 percent per year is the difference between an economy that doubles in size over 18
years and one that grows by less than 50 percent in the same period. Keeping
employment high is equally important. In the same way that you can never get back
the study time you lost when you went to the movies before an exam, it is impossible
for the economy to recover what unemployed people would have produced had they
been working during a downturn. You can’t get the lost time back. Our hope is that
policymakers can manage the country’s affairs so that we will stay on a high and
sustainable growth path. The levels of growth and employment aren’t the only things
of importance, though. Stability matters too. Together with financial crises,
fluctuations in general business conditions are the primary source of systematic risk.
As we have said a number of times, uncertainty about the future makes planning more
difficult, so getting rid of uncertainty makes everyone better off.
The Federal Reserve was founded to stop the financial panics that plagued the
United States during the late 19th and early 20th centuries. It took awhile to work out
the kinks in the system. As we have seen, the U.S. financial system collapsed again in
the early 1930s, as policymakers at the Federal Reserve watched. Between then and
2007, the Fed’s track record in preventing or mitigating crises improved substantially.
However, recent experience demonstrates that financial and economic catastrophes
are not limited to history books. Accordingly, financial system stability is an integral
part of every modern central banker’s job. It is essential for policymakers to ensure
that the markets for stocks, bonds, and the like continue to operate smoothly and
efficiently.
If people lose faith in financial institutions and markets, they will rush to low-
risk alternatives, and intermediation will stop. Savers will not lend and borrowers will
not be able to borrow. Getting a car loan or a home mortgage becomes impossible, as
does selling a bond to maintain or expand a business. When the financial system
collapses, economic activity does, too. The possibility of a severe disruption in the
financial markets is a type of systematic risk. Nothing that a single individual does
can eliminate it. Central banks must control this risk, making sure that the financial
system remains in good working order. The value at risk, not the standard deviation, is
the important measure here. Newer measures of risk seek to quantify the impact that
losses at an individual intermediary could have on the stability of the financial system
as a whole.13 When thinking about financial stability, central bankers want to
minimize the risk of a disaster and keep the chance of this maximum loss as small as
possible. Their struggles in the crisis of 2007–2009 revealed just how difficult it can
be to achieve these goals.
If you ask them, most central bankers will tell you that they do their best to
keep interest rates and exchange rates from fluctuating too much. They want to
eliminate abrupt changes. But if you press them further, they will tell you that these
goals are secondary to those of low inflation, stable growth, and financial stability.
The reason for this hierarchy is that interest rate stability and exchange rate stability
are means for achieving the ultimate goal of stabilizing the economy; they are not
ends unto themselves. It is easy to see why interest rate volatility is a problem. First,
most people respond to low interest rates by borrowing and spending more.
Individuals take out loans to purchase cars, new appliances, and the like, while
corporations issue more bonds and use the proceeds to enlarge their operations.
Conversely, when interest rates rise, people borrow and spend less. So, by raising
expenditure when interest rates are low and reducing expenditure when interest rates
are high, interest rate volatility makes output unstable. Second, interest rate volatility
means higher risk—and a higher risk premium—on long-term bonds. Risk makes
financial decisions more difficult, lowering productivity and making the economy less
efficient. Because central bankers control short-term interest rates, they are in a
position to control this risk and stabilize the economy.
Stabilizing exchange rates is the last item on the list of central bank objectives.
The value of a country’s currency affects the cost of imports to domestic consumers
and the cost of exports to foreign buyers. When the exchange rate is stable, the dollar
price of a car produced in Germany is predictable, making life easier for the foreign
automobile manufacturer, the domestic retailer, and the American car buyer. Planning
ahead is easier for everyone. Different countries have different priorities. While the
Federal Reserve and the European Central Bank may not care much about exchange
rate stability, the heads of central banks in more trade-oriented countries do. In
countries where exports and imports are central to the structure of the economy,
officials might reasonably argue that good overall macroeconomic performance
follows from a stable exchange rate.
c. Meeting the Challenge: Creating a Successful Central Bank
The decades prior to the global crisis of 2007–2009 were amazing in many
ways. The Internet and cell phones came into widespread use. Overall economic
conditions improved nearly everywhere, and especially in rapidly growing emerging
economies, such as those of Brazil, China, and India. Virtually across the globe,
inflation was lower and more stable than in the 1980s. In the United States, the
inflation rate fell from an average of 5.6 percent in the 1980s to 2.6 percent in the first
decade of the 21st century and continued to edge lower. Outside the United States,
improvements were even more dramatic. In 1980, nearly two-thirds of the countries in
the world were experiencing an inflation rate in excess of 10 percent per year and
nearly one in three was experiencing negative growth. Thirty years later, only one
country in nine had a two-digit inflation rate, while something like 150 countries were
growing at rates in excess of 2 percent per year. And not only was inflation lower and
growth higher for many countries, but both were more stable, until the global
financial crisis struck. What explains this long period of stability? A prime candidate
is that technology sparked a boom just as central banks became better at their jobs.
First, monetary policymakers realized that sustainable growth had gone up, so
they could keep interest rates low without worrying about inflation. Second, central
banks were redesigned. It wasn’t just that new central banks were established, like the
ECB. The structure of existing central banks changed significantly. The Bank of
England is more than three centuries old (its building in London has stood for more
than 200 years) but its operating charter was completely rewritten in 1998. The same
year brought major changes in the organizational structure of the Bank of Japan.
Federal Reserve operations have changed, too, fostering transparency and
accountability. The first public announcement of a move in the federal funds rate was
made on February 4, 1994. By 2012, the Federal Reserve had announced an official
inflation goal and had begun quarterly disclosures of economic growth and inflation
forecasts along with policy rate projections.
Many people believe that improvements in economic performance after the
1980s were related at least in part to the policy followed by these restructured central
banks. Improving monetary policy is not just a matter of finding the right person for
the job. There is an ample supply of highly qualified people. In fact, in many
countries there is a long history of central bankers who have tried but failed because
they weren’t free to pursue effective policies. Successful policymaking is as much a
consequence of the institutional structure and context as of the people who work in
the institutions. Nowhere is that more true than in central banking. Today, in the
aftermath of the financial crisis, economists are exploring how to improve financial
regulation, and reconsidering the role that central banks should play in financial
supervision. However, there remains a strong consensus among economists about the
best way to design a central bank for making effective monetary policy. To be
successful, a central bank must (1) be independent of political pressure, (2) be
accountable to the public and transparent in communicating its policy actions, (3)
operate within an explicit framework that clearly states its goals and makes clear the
tradeoffs among them, and (4) make decisions by committee.
The idea of central bank independence—that central banks should be
independent of political pressure—is a new one. After all, the central bank originated
as the government’s bank. It did the bidding first of the king or emperor and then of
the democratically elected congress or parliament. Politicians rarely give up control
over anything, much less something as important as monetary policy. But in the
1990s, nearly every advanced-economy government that hadn’t already done so made
the central bank independent of the finance ministry. The Banque de France became
independent in 1993. Political control of the Bank of England and the Bank of Japan
ended in 1998. And the new European Central Bank was independent from the day it
opened on July 1, 1998. Independence has two operational components. First,
monetary policymakers must be free to control their own budgets. If politicians can
starve the central bank of funding, then they can control the bank’s decisions. Second,
the bank’s policies must not be reversible by people outside the central bank. Prior to
1998, policymakers at the Bank of England merely recommended interest rate
changes to the Chancellor of the Exchequer, a political official. That is, interest rate
policy was ultimately decided by the British equivalent of the U.S. Secretary of the
Treasury. Since 1998, the Bank of England’s Monetary Policy Committee has made
those decisions autonomously. The same is true in the United States, where the
Federal Open Market Committee’s decisions on when to raise or lower interest rates
cannot be overridden by the president, Congress, or the Supreme Court.
Successful monetary policy requires a long time horizon. The impact of
today’s decisions won’t be felt for a while—several years, in many instances.
Democratically elected politicians are not a particularly patient bunch; their time
horizon extends usually to the next election. The political system encourages
members of Parliament and members of Congress to do everything they can for their
constituents before the next election—including manipulating interest rates to bring
short-term prosperity at the expense of long-term stability. The temptation to forsake
long-term goals for shortterm gains is difficult for most politicians to resist. In many
instances, for example, politicians would be inclined to select monetary policies that
are overly accommodative. They will keep interest rates too low, raising output and
employment quickly (before the election), but causing inflation to go up later (after
the election). Low interest rates are very popular because there are more borrowers
than lenders. Politicians with a short horizon also may be reluctant to use specific
central bank tools that are highly unpopular, even if doing so is the surest way to
prevent deflation or a financial crisis.
You can think of central bank independence as a means to overcome a classic
version of the time-consistency problem: If monetary policy were always made by
decision makers with a short horizon, people would doubt the long-run commitment
to price stability. (See the Applying the Concept: Time Consistency on page 405.) For
example, they might expect politicians to run inflationary policies at some time in the
future when it would be expedient to temporarily boost economic growth. As a result,
inflation expectations would tend to be high today. This implies that independent
central banks will deliver lower inflation—a conclusion for which there is substantial
evidence.14 In the same way, societies may be able to stabilize inflation and inflation
expectations efficiently if they delegate monetary policy to an independent central
bank that strongly prefers price stability.15 The reason is that the central bank’s
commitment to keep inflation low and steady in the future would be made credible by
its prudent inflation preferences, making policy time consistent. Like many problems
involving time consistency, this example illustrates how a constraint on policy
discretion (when legislators tie their hands and entrust monetary policy decisions to
the stability-oriented central bank) can lead to a more favorable policy outcome (in
this case, lower inflation).
In light of these considerations, governments have moved responsibility for
monetary policy into a separate, largely apolitical, institution. To insulate
policymakers from the daily pressures faced by politicians, governments must give
central bankers control of their budgets and authority to make irreversible decisions
and must appoint them to long terms of office. A similar need for independence
applies to the central bank’s role as lender of last resort, which may require unpopular
decisions (say, regarding the provision of credit to large banks or foreign banks) to
secure financial stability. The Fed’s extraordinary actions during the crisis of 2007–
2009, however successful in stemming a second Great Depression, led to a political
backlash in the United States against central bank independence. The consensus
among economists is strongly in favor of central bank independence.16 Yet, the Fed’s
emergency actions in the crisis—including large bailouts and extraordinary credit
provisions—may invite legislative interference in the day-to-day conduct of
conventional monetary policy, making it less effective in keeping inflation low and
stable. A far more acute threat arose during 2018, as President Donald Trump openly
attacked the Federal Reserve and his appointed chair, Jay Powell, for raising interest
rates (see Applying the Concept: The Threat toNFed Independence on page 405). In
2019, the President also proposed to nominate to the Board of Governors several
candidates who were widely seen as malleable, making the threat to Fed
independence seems greater than at any time in recent decades.
Proponents of central bank independence realized they would need to solve
this problem if their proposals were going to be adopted. Their solution was twofold.
First, politicians would establish a set of goals; second, the policymakers would
publicly report their progress in pursuing those goals. Explicit goals foster
accountability and disclosure requirements create transparency. While central bankers
are powerful, our elected representatives tell them what to do and then monitor their
progress. Technically speaking, legislatures usually grant central banks instrument
independence— the authority to use their tools as they see fit to achieve mandated
objectives—not goal independence. That means requiring plausible explanations for
their decisions, along with supporting data. That is precisely the approach endorsed by
current Federal Reserve chair Jay Powell at his 2018 ceremonial swearing-in:
“Congress has wisely entrusted us with an important degree of independence so that
we can pursue our monetary policy goals without concern for short-term political
pressures. As a public institution, we must be transparent about our actions, so that the
public, through its elected representatives, can hold us accountable.”
The institutional means for ensuring accountability and transparency differ
from one country to the next. In some cases, the government establishes an explicit
numerical target for inflation, while in others the central bank defines the target. In the
United Kingdom, the government sets a specific target each year; in the European
Union, the central bank is asked only to pursue “price stability” as its primary
objective; in the United States, the Federal Reserve is asked to deliver price stability
as one of a number of objectives. Similar differences exist in the timing and content of
information made public by central banks. Today every central bank announces its
policy actions almost immediately, but the extent of the statements that accompany
the announcement and the willingness to answer questions vary. The Federal
Reserve’s statements tend to be only a few paragraphs long, while the statements of
the ECB president and vice president may be several pages. The Fed holds a long
press conference quarterly when forecasts are updated; the ECB every month. Over
time, these differences in communications strategy have narrowed substantially, and
central bank statements are far more informative today than they were in the early
1990s. Until 1994, for example, the Federal Reserve didn’t announce its policy
decisions publicly. Secrecy, once the hallmark of central banking, is now understood
to damage both the policymakers and the economies they are trying to manage. For
monetary policy to be a stabilizing force, central bankers need to explain their actions
in periodic public statements, like the ones that follow every Federal Open Market
Committee (FOMC) meeting. In essence, the economy and financial markets should
respond to information that everyone receives, not to speculation about what
policymakers are doing. Thus, policymakers need to be as clear as possible about
what they are trying to achieve and how they intend to achieve it. There really
shouldn’t be any surprises.
We’ve seen that a modern central bank has a long list of objectives—low,
stable inflation; high, stable growth; a stable financial system; and stable interest and
exchange rates. To meet these objectives, central bankers must be independent,
accountable, and good communicators. Together these qualities make up what we will
call the monetary policy framework. The framework exists to resolve ambiguities that
arise in the course of the central bank’s work. Looking at the bank’s objectives, we
can see the problem. Setting a goal of low inflation is easy, but there are many ways
to measure inflation. The central bank needs to decide which measure to use and then
stick with it. Thus, the FOMC stated in each year since 2012 that an annual inflation
of 2 percent in the price index of personal consumption expenditures is consistent
over the long run with its mandate as given in the Federal Reserve Act. In the euro
area, the ECB seeks a rise of less than, but close to, 2Npercent, in the harmonized
index of consumer prices, or HICP. More important than the details, though, is the fact
that officials have told us what they are trying to do. Their statement helps people
plan at the same time that it holds officials accountable to the public.
The monetary policy framework also clarifies the likely responses when goals
conflict with one another. There is simply no way that policymakers can meet all their
objectives at the same time. Often, they have only one instrument—the interest rate—
with which to work, and it is impossible to use a single instrument to achieve a long
list of objectives. To take one example, by mid-2004, the U.S. economy had recovered
completely from the recession of 2001, and the inflation rate had started to rise. When
this happens, the appropriate response is to tighten policy, raising interest rates. So,
starting on June 30, 2004, the FOMC did just that. Seventeen times over the next two
years policymakers raised the target interest rate—each time by 25 basis points.
Obviously, if interest rates are changing every few months, they are not stable. More
important, raising the interest rate means reducing the availability of money and credit
at the risk of slowing growth. The goal of keeping inflation low and stable, then, can
be inconsistent with the goal of avoiding a recession. By the end of 2006, inflation
remained low while growth had slowed slightly. The financial crisis that erupted in
August 2007 began more than a year after the Fed had stopped raising rates.
Central bankers face the tradeoff between inflation and growth on a daily
basis. In March 2008, with inflation soon to rise above 5 percent for the first time
since 1991, the Federal Open Market Committee nevertheless cut its policy rate by an
outsized 75Nbasis points to 2.25 percent and highlighted in its statement that
“downside risks to growth remain.” Although the committee members expressed
concern about indications of rising inflation expectations, they judged that it was
more important to cut the policy rate in an effort to halt the financial contagion that
had resulted from the run on Bear Stearns, the fifth-largest U.S. investment bank. As
is often the case, policymakers were forced to choose among competing objectives
amid great uncertainty. Indeed, two FOMC members dissented, preferring a less
aggressive rate cut. As it turned out, when the financial crisis intensified later that
year, inflation worries gave way to deflation fears and the prospect of the deepest
recession since World War II. Because policy goals often conflict, central bankers
must make their priorities clear. The public needs to know whether policymakers are
focusing primarily on price stability or whether they are willing to allow a modest rise
in inflation to avoid a slowdown in economic activity. The public also needs to know
the roles that interest rate and exchange rate stability play in policy deliberations. This
important part of the policy framework limits the discretionary authority of the central
bankers, ensuring that they will do the job they have been entrusted with. Thus, it is
an essential part of the bank’s communication responsibilities.
Finally, a well-designed policy framework helps policymakers establish
credibility. For central bankers to achieve their objectives, everyone must trust them
to do what they say they are going to do. This is particularly important when it comes
to keeping inflation low and stable. The reason is that most economic decisions are
based on expectations about future inflation. We saw this relationship when we
studied the determination of interest rates: The nominal interest rate equals the real
interest rate plus expected inflation. The same is true for wage and price decisions.
Firms set prices based partly on what they believe inflation will be in the future. They
make wage agreements with workers based on expected future inflation. The higher
their expectations for future inflation, the higher prices, wages, and interest rates will
be. Expected inflation creates inflation. Stable inflation expectations help prevent both
high inflation and deflation. Successful monetary policy, then, requires that inflation
expectations be kept under control. The most straightforward way for the central bank
to do so is to announce its objectives, show resolve in meeting them, and explain its
actions clearly along the way. By making their preferences clear and their
commitments reliable, policymakers can overcome the time-consistency challenge. If,
instead, they are seen as likely to renege on a promise—such as the promise to keep
inflation low and stable—their policy’s impact will be diminished.
Should important decisions be made by an individual or by a committee?
Military planners know they can’t have groups making decisions in the heat of a
battle; someone has to be in charge. But monetary policy isn’t war. Monetary policy
decisions are made deliberately, after significant amounts of information are collected
and examined. Occasionally a crisis does occur, and in those times someone does
need to be in charge. But in the course of normal operations, it is better to rely on a
committee than an individual. Though extraordinary individuals can be trusted to
make policy as well as a committee, building an institution on the assumption that
someone of exemplary ability will always be available to run it is unwise. And given
the difficulty of removing a central bank governor—a feature that is built into the
central bank system—the cost of putting the wrong person in charge can be very high
(the same reason is often cited for preferring legislatures over monarchs). The
solution, then, is to make policy by committee. Pooling the knowledge, experience,
and opinions of a group of people reduces the risk that policy will be dictated by an
individual’s quirks. Besides, in a democracy, vesting so much power in one individual
poses a legitimacy problem. For these reasons, monetary policy decisions are made by
committee in all major central banks in the world: The Federal Reserve has its Federal
Open Market Committee the European Central Bank its Governing Council, and the
Bank of Japan its Policy Board. The number of members varies from 9 in the United
Kingdom and Japan to (currently) 25 at the ECB—but, crucially, it is always bigger
than one.
d. Fitting Everything Together: Central Banks and Fiscal Policy
Before a European country can join the common currency area and adopt the
euro, it is supposed to meet a number of conditions. Two of the most important are
that the country’s annual budget deficit—the excess of government spending over
revenues each year—cannot exceed 3 percent of GDP and the government’s total debt
—its accumulated level of outstanding bonds and other borrowings—cannot exceed
60Npercent of GDP.18 Once a country gains membership in the monetary union,
failure to maintain these standards is supposed to lead to pressure from other member
countries and (in theory) even to substantial penalties.19 Remember that the central
bank does not control the government’s budget. Fiscal policy, the decisions about
taxes and spending, are the responsibility of elected officials. But by specifying a
range of “acceptable” levels of borrowing, Europeans sought to restrict the fiscal
policies that member countries enact. For the European Central Bank to do its job
effectively, all the member countries’ governments must behave responsibly. While
fiscal and monetary policymakers share the same ultimate goal—to improveNthe well-
being of the population—conflicts can arise between them. Fiscal policymakers are
responsible for providing national defense, educating children, building and
maintaining transportation systems, and aiding the sick and poor. They need resources
to pay for these services. Thus, funding needs create a natural conflict between
monetary and fiscal policymakers. Central bankers, in their effort to stabilize prices
and provide the foundation for high sustainable growth, take a long-term view,
imposing 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
and look for ways to spend resources today at the expense of prosperity tomorrow.
For better or worse, their time horizon often extends only until the next election.
Some fiscal policymakers resort to actions intended to get around restrictions imposed
by the central bank, eroding what is otherwise an effective and responsible monetary
policy.
In the earliest days of central banks, a government that needed money would
simply order the bank to print some. Of course, the result was inflation and
occasionally hyperinflation. That is what led to the evolution of the independent
central banks. Today the central bank’s autonomy leaves fiscal policymakers with two
options for financing government spending. They can take a share of income and
wealth from the country’s citizens through taxes, or they can borrow by issuing bonds
in the financial markets. Because no one likes taxes, and officials fear angering the
electorate, politicians often turn to borrowing in order to finance some portion of their
spending. But a country can issue only so much debt. Beyond some limit, future tax
revenues will not cover the payments that are due to lenders. At that point, the only
solution is to turn to the central bank for the means to finance spending. As a technical
matter, the government will “sell” new bonds directly to the central bank—bonds that
no one else wants to buy. This process, often referred to as “monetizing the debt,”
eventually leads to inflation. In fact, if officials can’t raise taxes and are having
trouble borrowing, inflation is the only way out.
While central bankers hate it, inflation is a real temptation to shortsighted
fiscal policymakers. It is a way to get resources in their hands. The mechanism is
straightforward. The government forces the central bank to buy its bonds and then
uses the proceeds to finance spending. But doing so increases the quantity of money
in circulation, sparking inflation. The rise in inflation may ultimately do great damage
to the country’s well-being, but it also benefits fiscal policymakers: It reduces the
value of the bonds the government has already sold, making them easier to repay.
Inflation is a way for governments to default on a portion of the debt they owe. U.S.
fiscal and monetary policies to combat the crisis of 2007–2009 led many observers to
worry both about future inflation risks and about renewed financial instability. On the
fiscal side, in 2009, the federal government’s deficit neared 10Npercent of GDP for the
first time since World War II. On the monetary policy side, the Federal Reserve
lowered the policy interest rate close to zero and accumulated assets at an
unprecedented pace as it sought to prevent a meltdown of the financial system.
U.S. policymakers understood that both these policies eventually must be
reversed to prevent a large future inflation. A failure to reverse them eventually would
undermine investor confidence in U.S. Treasuries. By 2016, the federal deficit was
running below 3 percent of GDP, the Fed had begun to normalize its policy interest
rate, and it planned to shrink its balance sheet once that normalization was well
advanced. Partly as a result, long-term Treasury yields set record lows amid low
inflation expectations. While many politicians do act in their countries’ long-term
interests, there are plenty of examples of poor fiscal policymaking. In early 2002,
Argentina’s economy collapsed when banks refused to honor their depositors’
withdrawal requests. Unemployment skyrocketed, output plummeted, and the
president was forced to resign. The full story is complicated, but we can understand
one aspect of it without much trouble. During 2001, Argentina’s provincial
governments (the equivalent of the state governments in the United States) began to
experience significant budget problems. Their response was to start paying their
employees with government bonds. But unlike the bonds we normally see, these were
in small denominations—1, 2, 5, 10, 20 pesos, and so on. Not surprisingly, these
small-denomination bonds were immediately used as means of payment, becoming
money in effect. By mid-2002, this new form of money accounted for roughly 40
percent of the currency circulating in Argentina and the Central Bank of Argentina
lost control over the amount of money circulating in the economy.
So, we see that the actions of fiscal policymakers can subvert the best efforts
of central bankers. If the government can shut down the banking system and issue its
own money, then the central bank’s independence is irrelevant. The Federal Reserve,
the European Central Bank, the Bank of Japan, and the other central banks around the
world are independent only for as long as their governments let them be. When faced
with a fiscal crisis, politicians often look for the easiest way out. If that way is
inflating the value of the currency today, they will worry about the consequences
tomorrow. This brings us back to the criteria for inclusion in the European Monetary
Union. The founders of the system wanted to ensure that participating governments
kept their fiscal houses in order so that none of them would be tempted to pressure the
European Central Bank to create inflation and bail them out. Monetary policy can
meet its objective of price stability only if the government lives within its budget and
never forces the central bank to finance a fiscal deficit. In 2010, large fiscal deficits
propelled government bond yields sharply higher in several euro-area countries and
triggered a financing crisis in Greece, helping to weaken the euro. And, over the next
two years, the crisis spread to Ireland, Portugal, Spain, and then Italy. In response,
euroarea governments created a facility for lending to member states that face
difficulty borrowing in markets. As a condition of borrowing, a government is
required to restore fiscal discipline. As of this writing, the credibility and
independence of the European Central Bank have kept euro-area inflation
expectations low despite the region’s fiscal problems.
Stepping back and looking at the problem more broadly, we can say that
governments face the challenge of time consistency in setting fiscal policy, just as
they do in making monetary and regulatory policy. The value of any debt depends on
investors’ belief that they will be paid back. For a government, the problem is that
future fiscal authorities may have an incentive to renege on the promises their
predecessors made. If lenders believe that future developments will compel default,
the value of the debt will plunge today, regardless of how cautious the current
government may be. If, as a result, today’s government can no longer borrow, it may
turn to the central bank for direct monetary finance. Laws and other rules that
constrain future governments—such as the constitutional commitments of many U.S.
states to run balanced budgets or the mutual fiscal surveillance of the member
countries of the euro area—address the time-consistency challenge by making today’s
fiscal promises more credible. In the absence of fiscal credibility, rapid government
debt accumulation can lead to higher inflation expectations even in the face of
cautious monetary policy. Indeed, in a famous analysis, 2011 Nobel Prize winner
Thomas Sargent and coauthor Neil Wallace show that an otherwise credible, anti-
inflationary central bank cannot prevent high inflation if a government issues debt
without end.20 Put differently, to keep inflation low over the long run, (1) institutions
must ensure the time consistency of both monetary and fiscal policy, and (2) fiscal
policy must not dominate monetary policy.
