Introduction

Central banks are crucial to the functioning of any economy. Virtually every country has
one. In 1900, there were 18, but today there are more than 170 central banks throughout the
world. Central banks are the most powerful financial institutions in the world, because they
control the money supply of most modern economies. The earliest central banks, such as the
Bank of England, started as commercial banks that did some business with the government,
which, over time, took on more and more functions of a central bank. Other central banks,
such as the European Central Bank and the United States Federal Reserve were created as
central banks right from the start.

Central banks act as both the government's bank, which was their original purpose, and
as the bankers' bank, providing services to commercial banks, such as check clearing,
electronic payment systems, and providing liquidity when necessary. However, what
distinguishes central banks from other banks is their primary objective of maximizing
economic efficiency through monetary policy, by increasing or decreasing the supply
money or interest rates and overseeing the financial system to maintain the soundness of
financial institutions and markets. Central banks are not beholden to owners nor do they
seek profits. Any profits made by central banks are generally turned over to their
government.

Central banks became necessary to help manage the economy — without interference from
politicians — since financial problems can easily destroy the economy and problems in one
area or country can easily spread, as demonstrated in the recent Great Recession of 2007–
2009.

Central banks use monetary policy to regulate the economy. Increasing the supply of
money promotes both growth and inflation over the short run while decreasing it restricts
both. However, central banks do not make fiscal policy, which is the policy to determine
how public money will be raised and spent – a purview of the legislative and executive
branches of the government.

Policy Rules and Policy Discretion

The decisions of central bankers may be guided by policy rules or policy discretion. A policy
rule is a formula for determining the policy instrument and the policy, what reaction
should be implemented in response to observed changes in the economic state. The
advantages of the policy rule are that it is nondiscriminatory and predictable. Therefore,
consumers and businesses can make better plans for the future, which increases economic
efficiency. An example - Taylor rule. The Taylor rule bases the federal funds rate (in
Bangladesh, call money rate) to the nominal rate of interest implied by the long-term
equilibrium of the economy and the inflation target. The Taylor rule stipulates that the
federal funds rate should be increased when the output gap is positive, meaning that the
economy is operating above its long-term equilibrium, which leads to competition for scarce
resources, resulting in increased inflation. When the output gap is negative, then the
economy is operating below equilibrium, resulting in unemployment and underutilization of
capital, in which case, the federal funds rate would be decreased.
Policy discretion depends on the judgment of central bankers, and, thus, is not bound by
policy rules, so a better policy can be implemented for economic situations too complex to
be handled by simple rules. However, policy discretion can result in possible discrimination,
where one group benefits more than others. Moreover, policy discretion is not nearly as
predictable as a policy rule, but even policy discretion is guided by general principles.

Most central banks combine policy rules with policy discretion, since economies are too
complicated to be managed by simple rules, but rules do offer guidelines that may prevent
central bankers from making bad decisions.

Central Bank Independence

For a central bank to manage monetary policy effectively, it must have independence from
politicians seeking to manipulate monetary policy for their own short-term interest or for
the benefit of major donors. Several conditions can help assure central bank independence:

● a law specifying that central bank is to manage monetary policy according to well
defined objectives, such as limiting inflation or keeping unemployment low
● the central bank may not lend to the government, which would require creating
money for the loan, which would usually adversely affect monetary policy
● the government cannot influence, restrict, or overturn central bank decisions;
● top administrators of the central bank should be independently appointed for
specific terms, so that politicians cannot attempt to manipulate monetary policy by
pressuring or threatening the central bankers

In the United States, the Federal Reserve is largely independent, but the Board of Governors
is chosen by the president rather than members of the bank. In Bangladesh, the BB is a
public autonomous body, where the Governor as well as Deputy Governors are chosen by
the Government.

Arguments for public ownership:

– Central banks act in the ultimate public interest.
– Private ownership bias central banks toward self-serving profit-making
interests, hence increasing risk-taking and balance sheet troubles.
– The global financial crisis highlighted concerns that the profit-making target of
private shareholders could hamper them from saving the financial sector during
financial crises.

Arguments for private ownership:

– guarantees central bank independence
– restricts the distribution of dividends per share
– private owners are required to recapitalize the central bank in the case of losses
which lifts this burden off the fiscal budget.
The influence of central banks on their economies is limited because fiscal policy also affects
the economy, but fiscal policy, especially tax policy, is largely determined by elected
politicians, who have an incentive to try to maximize the economy in the short run to
increase their prospects of being re-elected.

During the last four decades, both theory and empirical evidence have suggested
that the more independent a central bank the more effective monetary policy is.
There are two key dimensions of central bank independence. The first dimension,
goal independence, encompasses those institutional characteristics that insulate
the central bank from political influence in defining its monetary policy objectives.
The second dimension, instrument independence, refers to the ability of the central
bank to freely implement policy instruments in its pursuit to meet its monetary
goals. The degree of independence of central banks depends largely on the preferences
and circumstances of each nation.

The Case for Independence: The main argument for central bank independence focuses
on potential inflationary biases that are likely to exert themselves as a result of political
pressure to boost output in the short run—mainly before elections—in order to finance
government spending to lower unemployment and interest rates. This is apt to lead to a
political business cycle, in which these expansionary monetary policies are reversed after
the election to limit inflation, unnecessarily leading to macroeconomic instability or booms
and busts.
Another argument for central bank independence is that the public not only generally
distrusts politicians in regard to making politically motivated decision, but also due to their
lack of expertise in conducting monetary policy. According to the principal-agent problem,
both politicians and the central bank have incentives to act in their own interest rather than
that of the public. Yet, the principal–agent problem is worse for politicians who have fewer
incentives to act in favor of public interest.
Third, politicians often opt for more central bank independence, especially when there is
disagreement between policymakers regarding unpopular macroeconomic decisions. In this
case politicians can grant more independence to the central bank in order to avoid public
criticism. This was the case in many EMEs that were forced to float or liberalize their
domestic currencies in order to gain integration with global financial markets. While this
was definitely in the long-run public interest, central banks took the blame for the massive
inflationary pressures due to higher costs of imported commodities.

The Case Against Independence

The main argument against central bank independence is that macroeconomic stability
can be best achieved if monetary policy is properly coordinated with fiscal policy. Since the
government is generally responsible for the macroeconomic performance of the country,
opponents of independence argue that it must have some degree of control over monetary
policy.
Opponents also argue that central banks are not necessarily immune from political
pressures. The theory of bureaucratic behavior suggests that the objective of a bureaucracy
is to maximize its own welfare, akin to consumer’s behavior that aims at maximizing
personal welfare. Thus, the central bank can pursue a course of narrow self-interest to
increase its power and prestige at the expense of public interest.

Monetary Tools to Regulate the Economy

Central banks can change the money supply through open market operations, by buying and
selling government securities, and by changing the reserve requirements for banks. To
increase the money supply through open market operations, the central bank buys
government securities from other banks or dealers and pays for the securities by simply
incrementing their accounts at the central bank by the amount of the purchase. When the
central bank sells government securities, it lowers the money supply of the buyers of the
securities, mostly banks or other dealers, by withdrawing the amount of the purchase from
their accounts at the central bank. Central banks could also adjust the reserve
requirements, which is the minimum that banks must hold as a percentage of their
transactions. Therefore, decreasing the reserve requirements increases the amount of
money available for lending and other transactions, while increasing the reserve
requirements has the opposite effect.

Central banks may also establish credit controls, by stipulating the amount of collateral
required for loans. In the United States, for instance, the Federal Reserve sets margin
requirements for the purchase of stocks and other securities.

Less-developed economies may have a smaller capital market and its citizens may save less,
so central banks in these countries may provide credit that would otherwise be unavailable
by lending directly to the government or by extending medium- or long-term loans to
commercial banks to finance domestic economic development.

One problem that all banks have — except for the central bank — is the potential to collapse
if all its depositors withdraw their money within a short time, which often happens when
people fear that their bank will go under. To prevent these runs on the bank, the central
bank stands ready as a lender of last resort. Because the central bank can create money,
it can lend financially stressed banks all the money necessary for them to continue
functioning. However, a lender of last resort will only provide liquidity for banks suffering
from a liquidity crisis, but not a solvency crisis, though it may be difficult to distinguish the
two, especially during economic downturns. A lender of last resort also creates a moral
hazard in that it allows banks to reduce their holdings of lower yielding, low risk assets for
higher-yielding, higher risk assets.

Central banks oversee the financial system and may also monitor other banks to ensure that
they are financially sound and are following wise management practices, since the collapse
of any bank can have serious financial repercussions throughout the economy, especially the
local economy.

Central Bank Objectives

The economic objectives of most central banks are to maintain financial stability in the
economy, while maximizing growth and employment. Stability is important because
financial instability is a systemic risk that affects the economy as a whole and cannot be
diversified away.

Consequently, central bank objectives have adopted objectives to accomplish their purpose,
including: low and stable inflation, high growth, high employment, and stable
financial markets and institutions. These factors must be optimized to achieve
maximal effect.
Economic planning is also greatly enhanced if the central bank is transparent in its
objectives. Transparency is achieved when the central bank follows specific objectives and
communicates its intentions to the public.

Low, Stable Inflation

When the amount of money increases faster than the economy, then inflation results. That
high inflation is bad for growth is evident from history, such as Germany after World War I,
the Ukraine in 1983, or Bolivia in 1985. The result of these cases of hyperinflation was
economic contraction. Hyperinflation makes financial planning much more difficult or even
impossible, and the economy becomes less productive because people and businesses obsess
about managing the hyperinflation.

Low stable inflation and price stability are desirable so that money can be useful as
a means of exchange, unit of account and as a store of value. If inflation is not
stable, then money cannot function as money: the use of barter will increase, and assets will
be purchased, even when they are not needed, to preserve value. Neither businesses nor
individuals can plan for the future; prices no longer indicate supply and demand of products
and services, causing economic inefficiency and stress. Higher inflation also varies more
than low inflation, creating greater uncertainty about the future. An uncertain future will
cause businesses to be reluctant to undergo long-term projects.

High inflation makes it difficult to plan for retirement. Indeed, it could be almost
impossible, since there is no way to know what the purchasing power of any given amount
will be 30, 40 or 50 years from now. People on fixed incomes will suffer.

Borrowing and lending will become difficult. Lenders would demand a higher rate of return
both because the nominal interest rate generally equals the real interest rate plus expected
inflation and because there is a risk premium for uncertainty. Hence, interest rates can
never be low when inflation is high.

Greater uncertainty about the future causes both people and businesses to be cautious. They
will not borrow money nor invest in long-term projects. Higher interest rates impede the
economy, and uncertainty increases interest rates further, since greater risk increases the
risk premium demanded by lenders to compensate them for their increased risk. Hence,
high inflation has the same result as high interest rates — both hinder the economy, causing
it to become less efficient. Indeed, the Federal Reserve was created in 1913, because of the
financial panics that plagued the United States in the 30 or 40 years before.

Although inflation should be low, it should not be negative because deflation makes loans

difficult to repay, which increases the default rate and people would hold on to their money
rather than spend it to let it increase in value. The government also profits from the
inflation — since the government creates money, it is the 1st to profit from it. Employers can
also benefit since wages always lags inflation, allowing them to collect higher revenues for
their products or services, thereby earning more profits before they increase wages.

One objective of the central banks is to maintain low interest rates. However, low interest
rates are frequently a secondary concern, because the manipulation of interest rates is a
main tool that central banks use to moderate the economy. When the economy is running
hot, and inflation threatens, the central bank raises the interest rate to decrease demand,
and when the economy is sluggish, interest rates are lowered to stimulate the economy.

Growth and Employment

Highest sustainable growth is desirable. When the economy fluctuates too much, the cycles
tend to reinforce each other. When the economy contracts, consumers stop spending,
thereby causing businesses to restrain their spending, thereby causing the economy to
contract even more.

The output of any economy depends on technology, capital, and people. However, these
factors of production have to be optimized to lead to the greatest potential output. When
the economy reaches its maximum potential output, then unemployment will be lowest, and
the benefit of the economy to society will be maximized.

Stable Financial Markets and Institutions

Financial stability is also important because financial intermediation is what brings

borrowers and lenders together, or investors and businesses. If financial institutions are not
stable, then neither people nor businesses will rely on them, and without them, economic
growth and efficiency will decline dramatically.

Exchange Rate Stability

Exchange rate stability facilitates international trade, but is not a main objective of most
central banks of developed countries, since domestic goals usually have greater
priority. Exchange rates are more important to emerging markets that depend on favorable
exchange rates for their export businesses. For instance, the Central Bank of China actively
buys United States Treasuries to keep its currency, the yuan, pegged at steep discount to the
United States dollar.

Adopted from: https://thismatter.com/