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Issues in Central Banking The Role of Central Banks

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1989
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Ensuring long-term price stability and the health of financial systems are important tasks. A view from the IMF

In recent years, efforts have been underway in a number of countries to strengthen the hand of their central banks. This reflects a growing recognition in many countries of the important contribution an effective central bank can make to economic performance. In light of this development, this article sketches out several features that characterize a strong and effective central bank:

  • a clear sense of its primary role and responsibility;

  • a medium-term perspective;

  • a solid professional base; and

  • public understanding.

In the final section, the issue of central bank independence is briefly addressed.

Monetary responsibilities

Although great diversity marks the activities of central banks throughout the world, it is through the conduct of monetary policy that a central bank has its most pervasive impact on an economy. Monetary policy allows central banks to have a significant impact on a broad range of macroeconomic developments, including growth, employment, inflation, interest rates, exchange rates, and the balance of payments. But other economic policy-making institutions—and particularly the budget authorities—also have a pervasive impact on economic developments. Without a reasonably clear understanding within a government concerning the primary responsibilities of the various policy-making institutions, economic performance is likely to suffer.

For a central bank, the establishment of monetary conditions conducive to price stability over time should be seen as its primary responsibility, and as the most effective way of promoting good economic performance in the long run. When pursuing this responsibility, a central bank is indirectly a dominant force in achieving low and stable interest rates and also exchange rate stability. In turn, a more stable financial and price environment provides the most effective way for a central bank to promote economic growth over time.

Achieving price stability is no easy task, since there are inevitable conflicts between short-term and medium-term goals. Monetary authorities must make decisions on a day-to-day basis, and often these decisions have significant effects on short-run economic developments in a country. One of the dilemmas that a central bank frequently faces is to choose between policy actions that would establish a better basis for longer-term price stability, and thus longer-term growth prospects, and the negative effects of those policy actions on economic growth in the short run. When inflation is on the march, an effort to tighten credit creation is likely to push interest rates higher, and this may initially slow down economic growth. But if it is to fulfill its primary responsibility, a central bank must be able to look beyond these short-run negative effects and concentrate on the long-term goal of price stability.

This article is based on comments made by Mr. Erb at a seminar sponsored by the Central Bank of Chile earlier this year.

Our experience with member countries also indicates that if a central bank has shown that it is able to control inflation over time, then it is less likely to be faced with severe short-run dilemmas. In other words, a well-established and credible central bank may well avert the negative effects on economic growth and employment of actions taken in the short run to suppress inflationary pressures.

The instruments and methods of managing monetary policy have been the subject of extensive studies by scholars and feature in almost daily discussion by economic journalists. As Paul Volcker, former Chairman of the Board of Governors of the US Federal Reserve System, put it rather succinctly, actual day-to-day decisions are really quite simple: “buy or sell”; in other words, create liquidity or reduce liquidity. Of course, the judgments that go into making those apparently simple decisions are very complex, and vary from country to country, depending on national, institutional, and economic conditions. For example, the size and structure of the financial and money markets in an economy and the competitiveness of its banking institutions are also important factors.

The institutional and economic structure of an economy has a central impact on the effective degree of autonomy of monetary policy decisionmaking by the central bank. The degree to which a central bank can influence monetary developments in a country will depend very importantly on the openness of the economy and the mobility of capital—factors that should be taken into account when designing monetary policy. But other influences can also be critical to the success of central policies.

Other influences

An important lesson derived from the experience of many Fund member countries is that fiscal policy plays a central role in the ability of a monetary authority to pursue its objectives. In a large number of countries, an increase in the fiscal deficit has put great pressure on the monetary authorities to finance that deficit, with consequent effects on money, exchange markets, and inflation. Further, decisions by the fiscal authorities on expenditures and the structure of taxes also affect the level of private sector savings and, in turn, the general economic environment in which monetary policy decisions are made. Thus, the Fund has learned to pay very close attention to the performance of fiscal policy and its interrelationship with monetary policy. Ideally, monetary and fiscal policies should be consistent with each other. But in most countries, the reality is often far from the ideal.

Beyond fiscal policy, the ability of a central bank to pursue its objectives steadily depends on the extent to which an economy is vulnerable to external shocks. For example, if an economy depends on one or two basic commodities (often the case in low-income developing countries), the ability of the monetary authority to maintain stable monetary conditions may be severely challenged. Liquidity growth and credit creation conducive to longer-term price stability may be difficult to implement in the short run, a period that may sometimes stretch over two or three years.

National financial systems

The management of monetary policy in pursuit of longer-term price stability also depends critically on the condition of domestic financial institutions. In many countries, including those that have an autonomous central bank, monetary policymaking becomes much more complex when the authorities are faced with widespread risk and insolvency among financial institutions. Often the existence of such risk necessitates, in the short term, special liquidity support by the central bank for these ailing institutions.

A key lesson that can be derived from the experience with financial crises in developing countries is that the implicit or explicit guarantees provided by the central bank for the performance of financial institutions should be tightly controlled. When such guarantees exist, it is vital for the central bank to have a hand in the regulation and supervision of financial institutions. Even if such supervision is conducted by a separate agency, a central bank should pay adequate attention to the quality and depth of that supervision. As we have seen in many countries, including in the United States, when financial institutions are not effectively supervised or regulated, difficulties can arise leading to very large financing problems for those institutions. In some instances, this may pose particularly difficult challenges for the management of monetary policy.

Another equally important lesson that can be drawn from the experience of many countries is that a central bank’s own balance sheet must be protected from actions of government that can weaken it, either because the enterprises that the central bank is required to support no longer remain solvent, or because they require large drawings from the central bank. For many countries that have had debt servicing difficulties and where the central bank was required to assume the responsibility for servicing the debt, this was a hard-learned lesson. In some other countries, where a central bank, either directly or indirectly, became involved in guaranteeing exchange contracts of private or public enterprises, sudden developments in the exchange markets had a dramatic impact on the degree of freedom of the central bank to manage, on a day-to-day basis, liquidity creation and monetary conditions in the country. This also imposed a financial burden on the central bank. Thus, it is important that central bank operations be open and transparent in order to avoid financing commitments that are not recorded in the balance sheet. In addition, central banks should be protected from assuming liabilities that should be the responsibility of the fiscal authorities.

The efficiency and competitiveness of a financial system will also affect the ability of the central bank to conduct monetary policy. This has led to financial sector reforms in many countries, industrial and developing, which have aimed at (1) efficiency in resource allocation, through a greater freedom for market processes and increased competition; and (2) a promotion of the domestic financial system and a market-based structure of interest rates. (See articles on finance for development in the September 1989 issue.)

The professional base

The experience of a number of countries indicates that the strength of a central bank and its ability to successfully perform its functions also depends on several institutional factors. The first one is the professional quality of its staff and management, regardless of the economic orientation of a country or the degree of autonomy of its central bank. Second, central banking institutions need an historical memory. In part, this depends on the quality and permanence of their staff and management, and on their cumulative experience of tested and viable policies. This helps them ride out waves of fads in the political, business, and academic communities about monetary policy. Third, it is critical for a central bank to have a solid empirical base, not only of economic data for the country but also knowledge of the institutional structure of the country.

Public understanding

Another important factor contributing to the strength and effectiveness of a central bank is public support and understanding for its role. This means that a central bank’s operations must be open and transparent, so that the public is aware of how it operates and the broad reasons for its actions. This does not mean, of course, that the public should be involved in day-to-day decisionmaking or aware of all the circumstances that affect decisions to buy or sell in any particular period. However, it is important for a central bank, through its public statements, publications, and testimony before political bodies (as occurs in many countries), to be open and accountable.

Central bank authorities also should participate in public discussions on the performance of economic policymaking in other institutions within the government. Thus, the central bank must have the independence to be able to critique fiscal policy as needed, and to critique other policies that may be jeopardizing the economic prospects of a country. Of course, this must be done, as it is in many countries, with some sensitivity. It is part of the process of gaining public recognition of the objectives and operational methods of the central bank, as well as a public understanding of how other developments in the economy influence the ability of the monetary authority to conduct its affairs. Without that public understanding, Fund experience shows that it is very difficult for a government to maintain a steady course in economic policymaking, in pursuit of longer-term economic growth.

Central bank independence

A number of countries are seeking to provide their central banks with legal and institutional arrangements to give protection from short-term political interference. This is a welcome development. While independence from the government is not a necessary condition and certainly not a sufficient condition to ensure a strong and effective central bank, it can make a significant contribution. At the same time, there is no such thing as absolute independence. As a practical matter, the effective degree of independence and public acceptance will depend on how well a central bank defines and performs its role over time.

While a political leader may ultimately be pleased with the outcome of a successful monetary policy, there will be moments of frustration when a central bank follows an independent course. This was reflected in the warm words of praise from former President Reagan several years ago at a dinner in honor of Paul Volcker, the departing Chairman of the US Federal Reserve Board. But, with a light touch of humor, President Reagan traced Mr. Volcker’s career through the private sector and government, and recounted that when Mr. Volcker completed his graduation work, he joined the Federal Reserve Bank of New York, and from there went to Chase Manhattan Bank, where he reported to David Rockefeller. He then went on to the Treasury Department and there, at various times, he reported to Secretaries Dillon, Fowler, Connally, and Shultz. Finally, Mr. Volcker became Chairman of the Federal Reserve Board. In that capacity, said President Reagan, Paul Volcker reported only to God.

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