Money and Banking: Lecture 31

Money and
Banking

Lecture 31


Review of the previous Lecture
• Central Bank:
• The Government’s Bank
• The Bankers’ Bank
• Objectives


Low, Stable Inflation
• Many central banks take as their primary
job the maintenance of price stability; they
strive to eliminate inflation.
• The rationale for keeping the economy
inflation-free is that money’s usefulness as
a unit of account and as a store of value is
enhanced when its purchasing power is
maintained.


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•

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Inflation degrades the information

content of prices and impedes the
market’s function of allocating resources
to their best uses.
The higher the inflation is, the less
predictable it is, and the more systematic
risk it creates.
Also, high inflation is bad for growth.


• While there is agreement that low inflation
should be the primary objective of
monetary policy, there is no agreement on
how low inflation should be.
• Zero inflation is too low, because it brings
the risk of deflation (a drop in prices)
which in turn results in increased defaults
on loans and a threat to the health of
banks.


• Furthermore, if inflation were zero, an
employer wishing to cut labor costs would
need to cut nominal wages, which is
difficult to do.
• A small amount of inflation may actually
make labor markets work better, at least
from the employer’s point of view.


High, Stable Real Growth

• Central bankers work to dampen the
fluctuations of the business cycle; booms
are popular but recessions are not.
• Central bankers work to moderate these
cycles and stabilize growth and
employment by adjusting interest rates.
• Monetary policymakers can moderate
recessions by lowering interest rates and
can moderate booms by raising them (to
keep growth at a sustainable level).


• Along with growth and employment,
stability is also important, because
fluctuations in general business conditions
are the primary source of systematic risk.



Financial System Stability
• Financial system stability is an integral
part of every modern central banker’s job.
• The possibility of a severe disruption in the
financial markets is a type of systematic
risk that central banks must control.


Interest Rate and Exchange Rate
Stability
•

Interest rate stability and exchange rate
stability are a means for achieving the
ultimate goal of stabilizing the economy;
they are not ends unto themselves.
Interest rate volatility is a problem
because:

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•
•

it makes output unstable as borrowing and
expenditure fluctuate with changing rates.
it means higher risk and a higher risk
premium and makes financial decisions
more difficult.


• Even though the exchange rate affects the
prices of imports and exports, stabilizing
exchange rates is the last item on the list
of central bank objectives.
• Different countries have different priorities
when it comes to the exchange rate;
• stable exchange rates are more important in
developing countries because imports and
exports are central to their economies.

The objectives of a Modern Central Bank

Low Stable
Inflation

Inflation creates confusion and makes
planning difficult. When inflation is high,
growth is low

High Stable
growth

Stable predictable growth is higher than
unstable, unpredictable growth

Financial System A stable financial system is necessity for an
Stability
economy to operate efficiently
Stable Interest
Rates

Interest rate volatility creates risk for both
lenders and borrowers

Stable Exchange Variable exchange rates make the revenues
Rates
from foreign sales and the cost of
purchasing imported goods hard to predict

Meeting the Challenge: Creating a
Successful Central Bank
•

•

The boom in the past decade with its
associated decrease in volatility may
have happened because technology
sparked a boom just as central banks
became better at their jobs.
Policymakers realized that sustainable
growth had gone up, so interest rates
could be kept low without worrying about
inflation, and central banks were
redesigned.


• Today there is a clear consensus about
the best way to design a central bank and
what to tell policymakers to do.
• A central bank must be
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•
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independent of political pressure,
accountable to the public,
transparent in its policy actions,

clear in its communications with financial
markets and the public.


Summary
• Central Bank
• Objectives
• Principles