Discuss the Role Central Banks Have Played in Counteracting
Discuss the role central banks (e. g. Fed, Bank of England) have played in counteracting the effects of the financial crisis. Argue how the monetary policy mandate might change in the future to avoid such crises. As stated by Buiter (2008) the Central Bank has three main tasks. These are; ‘(1) the pursuit of macroeconomic stability; (2) maintaining financial stability and (3) ensuring the proper functioning of the ‘plumbing’ of a monetary economy’.
The effectiveness of the Central Bank, during the financial crisis, will be discussed as well as how the Central Bank could change its monetary policies in order to avoid such a crisis in the future. The main focus will be on the Bank of England (BoE), the European Central Bank (ECB) and the Federal Reserve System (Fed). Each of the Central Banks have different objectives when it comes to monetary policy. The BoE concentrates on the target inflation set by the Chancellor of the Exchequer, which is 2 percent. The ECB has a similar objective although they can set target inflation themselves and it is usually just under 2 percent.
The Fed on the other hand has two main aims; ‘maximum employment, stable prices’ (Buiter 2008). When the crisis hit, the Central Banks made some attempts to counteract it. Firstly, they broadened their role as a lender of last resort. They started to include ‘liquidity support to non-deposit-taking institutions’ (Blanchard, 2010). This allowed them to intervene either directly or indirectly with more companies. This occurred at the start of the crisis where overnight interest rates rose sharply in Europe leading to the ECB responding with a liquidity injection of ‘€94. 8 billion worth of overnight repos’ (Cecchetti, 2008).
The Central Banks went on to drop interest rates. The aim of this was to allow banks to receive short-term funding at lower interest rates as well as reducing the demand for inter-bank loans (Cecchetti 2008). The hope was that lower interest rates would also encourage spending in the economy. However, This did not solve the problem. This is why the Fed decided to adopt a new policy where they introduced the Term Auction Facility (TAF). In America the Government debt was continuing to decline and there was a worry that the Federal Reserve would have to change their balance sheet management.
The TAF allowed banks to bid for reserves at interest rates ‘below the primary lending rate available at the time’ (Cecchetti 2008). The aim of this was to alleviate pressures in the long-term funding markets. This policy was also adopted by the ECB and BoE. A major problem which affected Central Banks in the North Atlantic region was that they made mistakes because they had not anticipated a financial crisis (Buiter 2008). The Fed cut its interest rates excessively due to political pressures and financial sector concerns.
This over-reaction of the Fed was partly due to the fact that they are the least independent of the three central banks and, as a result, felt political and financial sector pressures leading to the over-reaction. If the Fed were to become more independent then such an over-reaction might not occur. One option for Central Banks is to take into account the exchange rate. During the financial crisis the exchange rate was extremely volatile, due to large shifts in cash flows, which lead to ‘large disruptions in activity’ (Blanchard, 2010).
These large fluctuations cause balance sheets of companies to become unpredictable and can damage the trade sector leading to the financial sector becoming more unstable. These fluctuations might be minimized if the Central Banks took exchange rates into consideration as well as the inflation rate when determining monetary policies. Exchange rates can, however, not become too stable as this can create ‘greater incentives for contract dollarization’ (Blanchard, 2010). The financial crisis has shown that the zero bound nominal interest rates can cause huge problems.
Hence, it can be argued that target inflation rate could be increased. If the inflation rate were to be increased to 4 percent for example, then this would allow them to lower nominal interest rates to zero and then the real interest rate could be lowered to as low as negative 4 percent . Conventional monetary policy could then ease monetary policy by more than it could with a lower inflation target (Mishkin 2011). However, raising the inflation rate could cause problems. It has been found that the economy remains stable if inflation rates are below 3 percent.
Once the inflation rate is above this level people start to believe that the price level is not a credible goal for the Central Bank any more. This has occurred before in the United States leading the the great inflation in the 1970s (Mashkin 2011). Lastly Central Banks could use a price level target instead of the inflation target they use at the moment. Price level targeting has a major benefit which is that it is an automatic stabilizer. If demand where to drop this would cause a lower price level which would ead to the monetary policy raising the price level back to its target. This would cause a rise in inflation in the short run which would lower interest rates which would stimulate aggregate demand. There are, however, some problems when using price level targeting to determine monetary policy. Price level targeting can cause larger fluctuations in output as well as being harder to communicate to the public. The price level target would constantly be changing which is harder to explain the inflation target which remains constant.
In conclusion it I have discussed how the Central Banks have tried to counteract the financial crisis. I have found that as well as coming up with innovative ideas such as the TAF to try to counteract the crisis, they have also made mistakes. There have also been some ideas as to how to change monetary policy, Such as price level targeting and raising the inflation rate, in order to prevent such a crisis in the future. References: Blanchard, O. , Dell’Aricca, G. , Mauro, P. (2010), “Rethinking Macroeconomic Policy”, IMF Staff Position Note, http://www. mf. org/external/pubs/ft/spn/2010/spn1003. pdf Cecchetti, S. (2009), “Monetary Policy and the Financial Crisis of 2007-2008”, mimeo, http://fmwww. bc. edu/ec-j/Sems2008/Cecchetti. pdf Buiter, W. (2008), “Central banks and financial crises”, discussion paper series, http://eprints. lse. ac. uk/24438/1/dp619. pdf Mishkin, F. (2011), “Monetary Policy Strategy: Lessons from the Financial Crisis”, NBER Working Papers, https://mms. st-andrews. ac. uk/mms/module/2011_2/S2/EC2008/Content/Mishkin%20%282011%29%3A%20Monetary%20Policy%20Strategy/Mishkin2011. pdf