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MGT411 - Money & Banking - Lecture Handout 31

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  • 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.
  • 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 suitable level).
  • Along with growth and employment, stability is also important, because flactuations in general business conditions re the primary source of ystematic isk.

source of ystematic isk

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:
  • 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 economy to operate
Stable Interest Rates Interest rate volatility creates risk for both lenders and borrowers
Stable Exchange Rates Variable exchange rates make the revenues 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
  • Independent of political pressure,
  • Accountable to the public,
  • Transparent in its policy actions,
  • Clear in its communications with financial markets and the public

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