Central Banks as Enablers

In this lesson, understand the role of central banks within an economy. Understand central bank mandates, and policy rates of various central banks with examples of central banks of selected countries.

Central Banks play a pivotal role in driving social change and impact within the global arena. Central banks have a monopoly over the currency within an economy and serve as a banker to the government and to other financial institutions. Since the advent of fiat currency as economies moved away from the gold standard with the fall of the Brenton Woods agreement, central banks have become more powerful. One of the key roles of central banks is the smooth functioning of the financial system and regulating the country’s payment system. However, its role as a lender of the last resort along with its role of overseeing the monetary policy sets the Central Bank as the most significant institution within the country. This series covers the role of Central Banks within the monetary parlance; a role that helps in fixing the money supply and driving credit during the business cycles of an economy.

This is part of the Stabilization Series of online courses covered in Macroeconomics.

Inflation is impacted by two kinds of variability: Demand Push and Cost-Push. Demand push arises when demand for goods and services exceeds the supply of goods and services leading to the heating up of the economy. This happens when the economy is in a boom or expansion phase. Cost-push happens when the factors affecting the cost of goods and services rise example fluctuation in exchange rates, import prices, or capital flows that affect the price of cost of goods or services. A weakening exchange rate would inflate the prices of goods or services imported leading to an increase in  domestic inflation rate. Central Banks have a varied structure in tracking inflation it could range from a point estimate example 2 percent to target inflation between a range over different tenures.

Example, Reserve Bank of New Zealand targets CPI between 1 to 3 percent on average over medium term: future average inflation is 2 percent midpoint. 

YouTube: The middle Road 

The preamble or mandate of central banks varies. ECB, Bank of England, Riksbank follow a hierarchical method with a preference to price stability by monitoring inflation. On the other hand, FED, People Bank of China follow a dual mandate of focusing on (unemployment and inflation) and growth and stability of currency rate respectively.  The relationship between unemployment rate and inflation is covered in the lesson discussing the concept of Phillips Curve. Inflation and Unemployment have a inverse relationship although in recent times the curve is flattening i.e. there is no casual relationship between the two variables.

Consumer Price Index or Cost of Living index is an excellent tool to understand prices of selected goods or services and the consumption level of the population. CPI can be classified as core and headline inflation; core inflation is less volatile as compared to headline inflation. Core inflation is headline inflation minus the change in prices of energy, food, alcohol, and tobacco. (Some banks calculate core inflation as headline inflation minus food and energy). Many Central Banks track core inflation like the Federal Reserve, the Central Bank of United States of America, or headline inflation tracked by the European

Fig 4 Comparison of Core and Headline CPI fixed interest rate Sweden | The middle Road | Source Statistics Sweden and Riksbank

Central Bank. Core Inflation removes the transient effect of supply disruptions that increases the volatility of the consumer price index that might not be a true reflection of the state of the economy. Another good way would be to use the moving average method to smoothen out variations in the price levels. Another good way would be to use the moving average method to smoothen out variations in the price levels. Federal Reserve or the Fed follows a dual mandate of price stability (inflation) and unemployment rate. 

References and Suggested Reads 

  • Macroeconomics by N Gregory Mankiw
  • Macroeconomics Policy & Practice by Frederic Mishkin
  • Central Bank Tools & Liquidity Shortages by Stephen Cecchetti and Piti Disyatat
  • Brookings Article:  What is the repo market, and why does it matter?  Jeffrey Cheng & David Wessel
  • The Riksbank’s operational frameworks for monetary policy, 1885–2018  by Peter Sellin*
  • A Skeptic’s Guide to Modern Monetary Theory By N. Gregory Mankiw*
  • The Riksbank’s inflation target – target variable and interval
  • Inflation Targeting: A New Framework for Monetary Policy? Ben S. Bernanke and Frederic S. Mishkin