The role of Central bank

Published: 2018/01/09 Number of words: 2955

What are the roles and functions of central banks? Why do they need Economic staff? How far should central banks get involved in data collection and areas such as seasonal adjustment, as well as economic analysis?

Though Central Bank is viewed as one of the primary mechanisms of macroeconomic stabilization there are a number of arguments about other areas of Central Bank’s involvement. This paper will explore the different areas, including the role of Central Bank in effecting monetary policy and intervening body in exchange rate trades, Central Bank as a Last Lender Resort (LLR), and Central Bank as a regulatory body of the financial sector. Prior to further discussion, it is important to stress that the role of Central Bank and the scope of its involvement may vary due to the effect of different legislations and the presence of various stakeholders. Thus, US Central Bank does not act as a regulatory body of the financial sector (Driffill et al., 2005), whereas the intervention activity of Japan Central Bank requires the approval of other governmental bodies (Fujiwara, 2005).

This paper discusses the importance of Central Bank’s publications of economic forecasts and other information related to Central Bank’s views of the further state of macroeconomic trends. The discussion shows that this information is highly important for other market players and forecasting agencies as it reduces the information asymmetry.

The role of Central bank in macroeconomic stabilization
Chandavarkar (1996 cited in Geraats, 2002) claims that macroeconomic stabilization is the pivotal role of the Central Bank. The stabilization duties include such aspects as the stabilization of the domestic price level and exchange rate as well as domestic payment systems. The entry and operations of MNEs on the domestic market as well is the growing interdependence of the domestic economy on the business cycles of other leading global players might create serious financial repression (Geraats, 2002). The challenge is that these distortions of prices, including interest rates and foreign exchange rates, might cause severe fluctuations, create insolvency, and threat and disrupt the domestic economy (Beine et al., 2005). Beine & Bernal (2005) state that financial stability is critically important for the economic development of the country. They claim that in the absence of stability, economy becomes fragile, causes a moral hazard and reduces agents’ confidence. As a result, potential borrowers obtain lower wealth relative to the size of the projects. Whereas unpredictability and low confidence give rise to the agency costs and undermines the performance in the investment sector. Driffill et al. (2003) draw a parallel line between monetary policy and financial stability. They claim that the Central Bank’s activities designed to smooth interest rates and stabilize the price fluctuations lead to greater stability without disrupting market equilibrium.

Speaking of foreign exchange rates stabilization, Beine & Bernal (2005) differentiate between secret and open interventions. Referring to the practice of the Central Bank of Japan they state that these interventions are designed to minimize negative development of foreign exchange trades. Beine & Bernal (2005) claim that the reason for resorting to secret interventions (a practice which is used by a large number of developed countries) is to avoid sending the wrong signals to other market agents. As in Beine et al. (2005) the activity of the Central Bank is closely monitored by other market agents who form their expectations on the degree of the consistency of these interventions with the earlier data supplied by the Central Bank. In this case, if there is a controversy between intervention and prior activities of the Central Bank, market players can get confused and increase the overall noise on the market. As a result, it can cause higher fluctuations of rates and a greater degree of information asymmetry between the market agents. Hence, the objective of the Central Bank is to undertake stabilization measures which are consistent with the rational expectations of market agents. The failure to do so may increase the level of noise and cause severe market failures.

The national agenda and the reasons behind the changes of the inclusion policy
One of the main reasons directing changes for the inclusion policy was the social changes that the UK has been going through over the past two decades. The rise of the immigration flow has changed the British society and culture, and the schools should be ready to face this change. The Race Relation (Amendment) Act in 2002 sets guidelines for every school to have a policy which values diversity and challenges racism. What is more, the national curriculum regarding the taught information given to students needed to be changed in order to promote inclusion.

Another factor which brought changes to the agenda regarding inclusive learning was the demand for lifelong learning (Shapiro and Rich, 1999). David Blunkett’s Green Paper in 1998 put emphasis on lifelong learning and it requested the educational system to broaden the learning age. The policy of inclusion had to be changed once again so that for the educational system to consider adults as people who were willing to learn and as people who were actually in need of further education. The fact that adults were broadly entering the educational system has also brought changes to the national agenda and to the national curriculum. Because of increasing social competitiveness and subsequently the need for employment, the inclusion policy and the national curriculum were changed so as to provide to adult learners job-related learning opportunities. In this manner, the taught subjects were changed so as to include the ‘newcomers’ and their needs (Shapiro and Rich, 1999).

Finally, it should be noted that the national agenda cannot remain static (Halliday, 1998). Changes need to be made so as to address the needs of different students in a better manner. School curricula need to be responsive to social changes and should be ready to adapt to the differences which the several groups of students bring into the school environment (Halliday, 1998).

Central Bank’s forecasts and publications
According to Fujiwara (2005) the publications and forecasts of Central Bank are highly important. Having analysed the behaviour of other forecasting agencies prior to and after Central Bank’s publications, Fujiwara (2005) inferred that they adjust their predictions in line with Central Bank’s information. Geraats (2002) argues that market agents do not posses the wealth of information which might be accumulated by Central Bank. Carroll (2003) claims that most economic agents may be considered to form rational expectations based on professional forecasts, whereas professional agents base their forecasts on the data from the Central Bank’s reports. Romer & Romer (2000) state that Central Bank possesses information about the future development of the economy which is far beyond what is known to market participants. Hence, their predictions of future market development are based on asymmetric information which they have at their disposal. Under such conditions, the publications of Central Bank reduce the information asymmetry. And it is optimal for commercial forecasters to modify their forecasts and adopt the data of Central Bank. Geraats (2002) adds that Central Bank’s publications also act as a signal about the way Central Bank views the macroeconomic situation. On the basis of this information, market agents might predict the future steps of Central Bank and adjust their strategies accordingly. However, Geraats (2002) notes that this effect takes place only if market agents act rationally and have confidence in Central Bank’s consistency. As Huanga & Weib (2005) put it, rational expectation theory only works when the Central Bank as well as other authorities act consistently and have sufficient public credibility. With regards to developing economies and those in transition, the situation might differ. Huanga & Weib (2005) claim that, due to corruption, macroeconomic instability and weak governmental institutions, Central Bank might lack credibility.

When discussing the effect and role of Central Bank’s forecasts on expectation formation Geraats (2002) claims that the issues of transparency and credibility of Central Bank’s forecasts are crucial. Whereas transparency is defined as “the absence of asymmetric information between monetary policy makers and other economic agents” (Geraat, 2002). He claims that transparency, credible and consistent information reduces the likelihood of heterogeneous behaviour resulting from different expectations of the further macroeconomic development. Referring to the practice of developed countries, Geraats (2002) states that the Central Banks of New Zealand, Canada, the UK and Sweden specifically adopted new procedures to increase the level of transparency, known as explicit inflation targeting. The similar approach was also adopted by the Central Banks of Brazil, the United States, Japan and Switzerland.

With regards to credibility of the information supplied by the Central Bank employees, Cechetti & Krause (2002) note that this information shall create the proper set of expectations and reduce the noise which might stem from the Central Bank’s interventions and other activities. In other words, one of the major roles of information coming from the Central Bank is to create a set of expectations which will enable rational market agents to respond accordingly to the given information. As a result, the Central Bank might predict the possible behaviour of other agents and plan its policy accordingly. Moreover, the consistency of information coming from the Central Bank with its steps, promotes the potential efficiency of markets.

Central Bank as Last Lender Resort
Humphrey & Keleher (2002) believe that Central Banks traditionally played the role of LLR. Both Humphrey & Keleher (2002) and Gerdrup (2005) state that acting as LLR Central Bank minimizes the potential risk of disruption of the whole banking system. As Gerdrup (2005) makes it clear, under certain situations, the market and interest rate volatility might create a problem of insolvency where a single bank might fail to meet its obligations in intra-bank relations. This case might create a domino (knock-on) effect, creating a negative impact on the whole banking system. At the same time, Driffill et al. (2003) argue that the excessive support of banks in terms of LLR activities might induce a form of moral hazard. Referring to the case of the US banks, they claim that commercial banks and other financial institutions may overestimate the favourability of stable macroeconomic climate and the Central Bank support. As a result, these players might commit to risky portfolios of loans and deposits failing to take into account present market risks. Consequently, the short-term exchange rate fluctuation might create the insolvency problem and create a necessity for Central Bank to bail-out the banks which are in trouble. The threat for macroeconomic stability is that the mass insolvency might undermine the Central Bank’s capacity to cover all insolvency issue, meaning the whole financial system might face a crisis.

To avoid the development of a similar scenario, the Federal Reserve System warns market participants in advance about its capacity to act as LLR (Driffill et al., 2003). In other words, in periods of high interest volatility banks have to adopt a risk aversive approach. In this respect Borchgrevink & Moe (2004) call for tighter monitoring by Central Bank’s of banks’ and financial institutions’ risk management policies. Gerdrup (2005) notes that in Norway the Central Bank collaborates with the Financial Supervisory Authority with regards to monitoring the activities of individual institutions. The latter body is granted with broad powers to intervene in case it foresees that the activity of a certain financial institution (private and public) might create a threat to stability.

Borchgrevink & Moe (2004) suggest that the Central Bank should limit LLR activities and force market agents to be more prudent. Driffill et al. (2003) take the opposite stance. They claim that certain types of risks are not predictable due to the fact that banks borrow short and lend long. Hence, the sudden inflation scare might cause a dramatic short-term change of rates; induce a tightening of monetary policy and cause insolvency issue of the number of banks.

Central Bank as regulatory and monitoring body of financial system
Ioannidou (2003) believes that in a large number of countries Central Banks combine functions of macroeconomic stabilization with the management of a financial system. Borchgrevink & Moe (2004) claim that in many transition economies the Central Bank acts as the backbone of the financial system, combining both macroeconomic stabilization and micro control of the emerging financial system. Such a combination creates various debates. The comparative studies of Heller (1991) and Goodhart & Schoenmaker (1992) showed that Central Banks’ macroeconomic decisions might be affected by its involvement in the management of the financial system. The roots of this influence might stem from the conflict of interests. Whereas the desires for certain levels of interest rates (to resolve inflation issues or exchange rate matters) might go against the policy of increasing the profitability of the banking sector. The problem is that due to the nature of banks’ activities (borrow for short periods and lending for long periods) the banks might suffer from the adverse effects of higher interest rates on the solvency. In this regard, Russia’s crisis of 1998 demonstrates the adverse outcomes of this combination. In Russia, the Central Bank’s involvement in the management of the financial system undermined its prudence on the macroeconomic scale and led to an extensive financial crisis. According to Ioannidou (2003), policymakers in the UK, Japan, and several Scandinavian countries recently removed their Central Bank from its role in bank supervision, whereas the European Central Bank was given no supervisory responsibilities, to avoid a conflict of interest.

Goodhart & Schoenmaker (1992) claim that the conflict of interest between different duties of the Central Bank stem from the different nature of regulatory and monetary functions. The regulatory functions might require the microeconomic decisions of short-term nature. Quite to the contrary, the macroeconomic activities are long run and might go at the cost of short-term losses. Ioannidou (2003) put it in the following way: “Monetary policy is usually countercyclical, while the effects of regulation and supervision tend to be procyclical, offsetting to some extent the objectives of monetary policy”.

The other side effect of the Central Bank’s combination of different duties is the issue of credibility. If a bank failure occurs when the Central Bank holds responsibility for bank monitoring and control, the market agents might reduce their level of perceived trust towards that bank.

This paper outlined the role of Central Bank and the degree of its involvement in the macro and microeconomic development of a country. The discussion showed that Central Bank is the pivotal element which provides the macroeconomic stabilization of a country by adjusting interest rates and undertaking the foreign currency exchange interventions. Such activities prevent possible disruption and minimize the side effects of the activities of both global and large local market agents.

The discussion also highlighted the role of Central Bank as the disseminator of the economic forecasts regarding the future development of the economy. The closer investigation of the essence of these forecasts revealed that Central Bank needs to be greatly involved in collecting information about the market. The data regarding business cycles, economic trends and other important dimensions of a country’s development serves for Central Bank’s employees as the basis to develop future forecasts, devise its policy and spread information to other market agents. As a result, this data minimizes information asymmetry and provides a more fruitful basis to make the Central Bank procedures more effective.

The discussion outlined the role of Central Bank as the LLR. It showed that under certain conditions, Central Bank becomes the last ditch resort for banks which experience insolvency problems. The support of Central Bank prevents the crisis spreading into and affecting other market agents and the whole economy of a country. At the same time, the paper stressed the importance of a prudential approach as excessive support might cause the effect of moral hazard and lead to an extensive financial crisis.

This paper considered the regulatory function of Central Bank. The considered views of various academics showed that under certain conditions Central Bank might shape the development of the financial system. Nevertheless, the possible conflict of interests might arise and affect the prudence of its macroeconomic policy or its ability to handle microeconomic issues. Hence, the governments of the developed countries tend not to endow Central Banks with confronting obligations and rights.

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