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Chapter 15 Central Banks in the World Today Conceptual Problems In 1900, there were 18 central banks in the world; today, there are about 185. Why does nearly every country in the world now have a central bank? Answer: A central bank plays a vital role in any nation’s economy. By controlling the rate at which it creates paper money, the central bank is able to affect inflation and economic growth. The power of a central bank is based on its monopoly over the issuance of currency. Economics teaches us that monopolies are bad and competition is good. Would competition among several central banks be better? Provide arguments both for and against. Answer: Competition could force central banks to become more efficient and would increase accountability. However, the central bank’s monopoly over the issuance of currency is what allows it to control money growth and inflation. Explain the costs of each of the following conditions, and explain who bears them. a. Interest-rate instability b. Exchange-rate instability c. Inflation d. Unstable growth Answer: Interest-rate instability makes output unstable. It also increases risk and therefore the risk premium on bonds. With a higher risk premium, it is more costly for firms to borrow. Firms will decrease their investments, which will hurt economic growth. Exchange-rate instability makes the revenue from exports and the costs of imports unpredictable. This hurts individuals engaged in foreign trade. This problem is particularly severe in emerging markets countries. Inflation creates uncertainty, which reduces investment and hurts growth. When inflation is higher than expected, the real value of the payments received by lenders falls. Someone on a fixed salary is also hurt by higher than expected inflation. When growth is unstable, people are less sure about their future incomes and are less willing to borrow. Another reason for the decrease in borrowing is that the uncertainty associated with unstable growth increases the risk premium and makes borrowing more costly. Lower levels of borrowing reduce investment and hurt future growth. Provide arguments for and against the proposition that a central bank should be allowed to set its own objectives. Answer: One could argue that a central bank should be able to set its own objectives so as to be free from political influence. However, this would reduce accountability, since the central bank would be able to change its objectives in accordance with the monetary policy it is following at any particular time. A euro-area country that runs very large public deficits or shows a persistently high and rising debt-to-GDP ratio violates the provisions of a recent treaty aimed at promoting fiscal stability. Explain how this fiscal violation poses a challenge for the ECB in the form of moral hazard.
Answer: The violation of the provisions of the treaty by a euro-area country poses a moral hazard problem for the ECB because, if the country defaults on the debt, the ECB would need to react. The most obvious response would be that the ECB buys the bonds of the violator. However this action risks signaling to other countries that they, too, will receive central bank support if they violate the provisions. In addition, private-sector bond buyers may view central bank purchases as insuring them against the default risk of countries that run poor fiscal policies. Default risk premia that are persistently too low encourage governments to take greater fiscal risks. How do long terms of office for central bankers help overcome the problem of time inconsistency in monetary policy? Answer: Long appointments allow central bankers to resist reneging on desirable long-run policies for short-term gains. Long terms also allow central bankers to develop reputations that enhance policy credibility. What problems does a central bank face in a country with inefficient methods of tax collection? Answer: If the government cannot efficiently collect tax revenues, it may pressure the central bank to buy its debt. A central bank that persistently monetizes government debt risks high and rising inflation. The Maastricht Treaty, which established the European Central Bank, states that the governments of the countries in the euro area must not seek to influence the members of the central bank’s decision-making bodies. Why is freedom from political influence crucial to the ECB’s ability to maintain price stability? Answer: Because politicians are elected for short terms, they have an incentive to create short-term prosperity at the expense of future inflation. If they can influence the central bank, they will push for expansionary monetary policy that increases economic growth in the short run but leads to inflation in the long run. Transparency is a key element of the monetary policy framework. Explain how transparency helps eliminate the problems that are created by central bank independence. In what way did the financial crisis of 2007-2009 emphasize the importance of central bank transparency? Since 1993, the Bank of England has published a quarterly Inflation Report. Find a copy of the report on the bank's Web site, hwww.bankofengland.co.uk. Describe its contents, and explain why the bank might publish such a document. Answer: Central bank independence takes significant power away from elected politicians and gives it to a set of appointed officials. By requiring central bankers to communicate regularly with the public and explain exactly what they are doing and why, transparency makes central bankers more accountable, consistent with representative democracy. In volatile, uncertain times, central bank transparency helps reduce uncertainties that arise from the central bank’s own policies and actions. During the 2007-2009 financial crisis, the Federal Reserve’s transparency in communicating its new, unconventional policy approaches to the public made policy more predictable and effective. The U.K. Inflation Report describes current economic conditions and makes projections for the future. It also explains the reasoning behind the Bank of England’s interest rate setting. Publishing the report makes it more difficult for the Bank of England to deviate from its focus on keeping inflation low and stable. By encouraging time-consistent monetary policy, publication of the report makes the central bank’s anti-inflation commitment more credible and helps to anchor inflation expectations. While central bank transparency is widely accepted as a desirable, too much openness may have disadvantages. Discuss what some of these drawbacks might be. Answer: Disclosing too much information may, in fact, obscure the key message the central bank is trying to get across. Disclosing details of the debate that took place to make a policy decision or having different policy makers air conflicting views might undermine the commitment to and credibility of the policy eventually agreed upon. Knowing that the minutes of policymaking meetings will be made public might stifle open and productive discussions to form the basis of policy decisions. Which do you think would be more harmful to the economy – an inflation rate that averages 5 percent a year that has a high standard deviation or an inflation rate of 7 percent that has a standard deviation close to zero? Answer: Inflation of 5 percent with a high standard deviation is likely to be more harmful to the economy. The less predictable inflation is, the more it distorts economic decisions and the more systematic risk it creates. Suppose the central bank in your country has price stability as its primary goal. Faced with a choice of having monetary policy decisions made by a well-qualified individual with an extremely strong dislike of inflation or a committee of equally well-qualified people with a wide-range of views, which choice would you recommend? Answer: In general, decision-making by committee is considered a better choice as it allows for the pooling of knowledge and experience and reduces the risk that policy will be dictated by one person’s quirks. Given that the individual in question is not democratically elected, it is also more legitimate to entrust monetary policy decisions to a group rather than an individual. Suppose the president of a newly independent country asks you for advice in designing the country’s new central bank. For each of the following design features, choose which one you would recommend and briefly explain your choice: Central bank policy decisions that are irreversible or central bank policy decisions that can be overturned by the democratically elected government. The central bank has to submit a proposal for funding to the government each year or the central bank finances itself from the earnings on its assets and turns the balance over to the government. The central bank policymakers are appointed for periods of four years to coincide with the electoral cycle for the government or the central bank policymakers are appointed for 14-year terms. Answer: You should choose irreversible central bank decisions as the priorities of the central bank tend to be longer term than those of politicians who may be tempted to reverse any central bank decisions that could hurt their chance of reelection. You should choose for the central bank to be free to control its own budget. Otherwise, politicians who hold the purse strings could use this power to influence central bank decisions to their own benefit. You should choose to elect central bank policymakers for long terms in office to enable them to pursue the long-term goals of the central bank. “A central bank should remain vague about the relative importance it places on its various objectives. That way, it has the freedom to choose which objective to follow at any point in time.” Assess this statement in light of what you know about good central bank design. Answer: This statement is inaccurate. In order for the central bank to be credible, it needs to communicate clearly its policy goals and the trade-offs between them. This allows the public to know how the central bank will react in various situations and helps to keep inflationary expectations under control. Put differently, narrowing the central bank’s scope for policy discretion can add to the credibility of its policy commitments, helping to overcome the challenge of time consistency. The long list of central bank goals includes the stability of interest rates and exchange rates. You look on the central bank Web site and note that they have increased interest rates at every one of their meetings over the last year. You read the financial press and see references to how the exchange rate has moved in response to these interest-rate changes. How could you reconcile this behavior with the central bank pursuing its objectives? Answer: This behavior is perfectly consistent with a monetary policy framework that considers low and stable inflation as a more important objective than interest-rate and exchange-rate stability. Often, there are trade-offs to be made among competing objectives. Increasing interest rates may have been necessary to curb emerging inflationary pressures. Provide arguments for why you think the financial crisis of 2007-2009 did or did not compromise the independence of the Federal Reserve. Answer: To argue that the Fed’s independence was compromised, you could point out that, during the crisis, the Fed cooperated closely with the Treasury to restore financial stability and engaged in behavior that it would not normally deem appropriate. For example, during the take-over of Bear Stearns by JPMorgan Chase, the New York Fed accepted risky assets as collateral. You could also refer to the popular backlash against the Fed for its involvement in the bailouts of companies such as AIG that has led to legislative proposals for more oversight of the Fed that would compromise its independence. To argue that the Fed’s independence has not been compromised (in the absence of any legislative changes so far), you could point out that its actions in cooperating with Treasury to restore financial stability were perfectly consistent with its goals. Currently, the Federal Reserve’s anti-inflationary credibility appears to be intact and as long as its extraordinary actions are unwound before inflationary pressures emerge, it has not compromised its independence. Suppose in an election year, the economy started to slow down. At the same time, clear signs of inflationary pressures were apparent. How might the central bank with a primary goal of price stability react? How might members of the incumbent political party who are up for reelection react? Answer: In this case, the appropriate monetary policy is to tighten monetary policy, increasing interest rates to curb the emerging inflationary pressures in pursuit of the long-run goal of price stability. In contrast, it is likely that the politicians due for reelection would be more concerned with the slowdown in the economy and be in favor of a cut in interest rates. In the absence of influence over an independent central bank, they may push for immediate increases in government spending or reductions in taxes. Assuming that they could, which of the following governments do you think would be more likely to pursue policies that would seriously hinder the central bank’s pursuit of low and stable inflation? Explain your choice. A government that is considered highly creditworthy both at home and abroad in a politically stable country with a well-developed tax system, or A government of a politically unstable country which is heavily indebted and considered an undesirable borrower in international markets. Answer: The government described in b) would more likely be tempted to force the central bank to buy its bonds to finance increased spending. In a politically unstable country, collecting taxes or raising funds by selling bonds to citizens will be relatively more difficult than in a) as would borrowing on international markets. Getting the central bank to print money may be the only option to increase spending. The increase in the quantity of money in circulation would lead to higher inflation in conflict with the central bank’s goal. Suppose the government is heavily in debt. Why might it be tempting for the fiscal policymakers to sell additional bonds to the central bank in a move that it knows would be inflationary? Answer: In this case, the inflation would benefit the fiscal policymakers, as it would erode the real value of its outstanding debt, making it easier to repay. Inflation also increases nominal income and the tax revenues collected at a given tax rate, again making it easier to repay debt. “A central bank cannot operate effectively if it has negative net worth.” State whether you agree or disagree with this statement and provide a rationale for your choice. Answer: A choice of “agree” could be supported by pointing to threats that are largely political in nature. For example, the need for the central bank to be recapitalized by the fiscal authority could undermine its independence and/or credibility. Or the reduction or elimination of remittances to the fiscal authority could prompt legislative action that threatened the central bank’s independence. A choice of “disagree” could be supported by arguments that are economic in nature. For example, because the central bank can issue liabilities regardless of its net worth – it will never be illiquid. You could argue that future seignorage revenue could offset a moderate capital shortfall quite quickly or that negative net worth of the central bank is meaningless as the central bank is part of the government and so its balance sheet should be consolidated with the wider government balance sheet. Explain how the statement by the FOMC in 2012 that an annual inflation rate of 2 percent over the long run is consistent with its mandate can help the Federal Reserve fulfill that mandate? Answer: The Federal Reserve stating its objective explicitly can help anchor inflationary expectations. A credible central bank will be expected to alter policy in the future to keep inflation near its target. Announcing the target raises the cost of reneging on the central bank’s commitment to price stability, making the policy time consistent. As inflation expectations inform firms’ pricing and wage decisions, stabilizing inflation expectations around 2 percent prevents actual inflation from deviating too far from this level for long, thus helping the achieve the goal of price stability. Data Exploration According to Figure 15.1, New Zealand in the 1970s and 1980s combined high inflation with relatively little central bank independence. In 1989, New Zealand became the first country to adopt an inflation target. How did this policy regime shift affect inflation? Plot the inflation rate based on New Zealand’s “core” consumer price index (FRED code: CPGRLE01NZQ659N) beginning in 1970. Was inflation after 1990 lower and more stable than before? Download the data and compute the average and the standard deviation of inflation for: (a) the period through 1989 and (b) the period from 1990 to the present. Answer: The data plot below confirms that inflation was higher and more variable prior to the policy shift in New Zealand. In the 1970-1989 period, inflation averaged 11.8 percent with a standard deviation of 4.4 percent. From 1990 to early 2015, inflation averaged 2.1 percent with a standard deviation of 1.3 percent. Organization for Economic Co-operation and Development, Consumer Price Index: OECD Groups: All Items Non-Food and Non-Energy for New Zealand© [CPGRLE01NZQ659N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPGRLE01NZQ659N. Financial stability is a goal of most central banks. Based on a graph showing the evolution of the European Central Bank’s assets (FRED code: ECBASSETS), how important was this goal for the ECB (a) before 2007, (b) during the crisis period of 2007-2009, and (c) when the euro-area crisis intensified in 2011-2012? Answer: (a) Prior to 2007, ECB assets rose steadily, reflecting tranquil economic conditions. (b) Following the Lehman failure in 2008, central bank assets rose quickly as the ECB injected liquidity into the banking system to counter financial market disruptions. (c) Beginning in late 2011, the ECB again expanded its balance sheet rapidly to counter the runs on banks in several euro-area countries. More recently, the ECB has undertaken “quantitative easing” (acquiring a large volumes of assets; see chapter 18) in order to stimulate GDP growth and to move inflation closer to the goal of close to, but less than 2 percent. As a result, its balance sheet expanded again after 2014, setting a new record in 2016. European Central Bank, Central Bank Assets for Euro Area (11-19 Countries)© [ECBASSETS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/ECBASSETS. Interest rate stability is a common goal of central banks. When has the Federal Reserve been relatively successful at keeping interest rates stable? Compare quarterly changes since 1965 of the federal funds rate (FRED code: FEDFUNDS) with the level of inflation based on the percentage change from year-ago levels of the consumer price index (FRED code: CPIAUCSL). Are stable interest rates associated with high or low inflation? Why? Answer: Higher inflation prior to 1985 was associated with volatile interest rates. Why? The first reason is that the goal of low, stable inflation is a higher policy priority than the goal of stable interest rates. Consequently, when inflation is high, the goal of lowering it makes the Fed willing to tolerate volatile interest rates. Another reason is that inflation itself often is more volatile when it is high, resulting in more volatile policy rates. A third reason is that low inflation expectations make it easier to keep inflation stable without large changes in nominal interest rates: Stable inflation means that a small change in the nominal interest rate also changes the real interest rate that influences economic activity. To what extent has the Federal Reserve “monetized” government debt? Plot since 1970 the change from a year ago (measured in billions of dollars) in gross federal debt (FRED code: FYGFD) and the change from a year ago (measured in billions of dollars) in the federal debt held by the Federal Reserve System (FRED code: FDHBFRBN).
Answer: By examining the annual change in the gross federal debt, we are evaluating new Treasury borrowing (net of redemptions) in the credit market. Similarly, the annual changes in the Federal Reserve holdings represent net purchases by the Fed during the year. In the aftermath of the 2007-2009 crisis, Fed purchases of government debt issues reached record levels and also were large as a share of new federal debt. indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
