Term Paper for ECO 407
University of Toronto
The term paper will explore what the role of central banks has been traditionally and how that has been changing over time. Central banks historically have had three chief functional roles (Goodhart, 2010). Firstly, maintenance of price stability under monetary administration such as gold standard or fixed exchange rate or inflation target is a crucial role. Secondly, central banks help maintain financial stability and improve financial infrastructure of the economy. Thirdly, they maintain the state’s financing needs at times of crisis or recessions as well as prevent wasting of financial powers such as by preventing debasement and misuse of inflation tax. Prior to the 2007-2008 financial crises, the conduct of monetary policy by central bank by varying the short term interest rate to achieve an inflation target, was performed well. That was done independently of the government in general. However, it was observed that this process while achieved price stability was far from achieving financial stability. In the paper, this turns to question this policy and discuss if this policy should be changed to a great degree? What other policy choice can be taken?
Victorian Era: The balance between the above objectives has shifted at different times with state financing being dominant during war times. During normal times however, the shifting between monetary policy (stable prices) and financial stability role have has been dominant. I want to discuss three important periods from past namely : the Victorian era (1840s to 1914), the decades of government control (1930s to 1960s), and the 1980s to 2007 period referred as triumph of the markets. To understand how the behaviour of central banks has evolved from the earliest times to and since the most recent financial crisis of 2007-2008, it is crucial to delve into the empirical evidence provided by the happenings of the above mentioned periods. In the Victorian era – ‘the real bills doctrine’- governments would have surpluses during no-war periods and deficits in times of war. As per this view, the purchase of government debt was as bad as speculative bills or open market operations by central banks. The fed at that time was unwilling to undertake expansionary open market purchases of government debt during depressions because their models, which they thought were not related to output or trade but rather on wars, suggested that this would cause inflation and was wrong (Meltzer, 2002). This is important since it sheds light on the misunderstanding that central banks should only do open market operations in government debt. Also this gives reasoning to both monetary policy (price stability) and financial stability. Since this 1840s to 1914 period, such a theory where both financial and price stability concerns are met have not been seen. The real-bills policy was not right since it simply assumes that the private sector is self-stabilising – this was transparent when the Great depression hit and the assumption broke down and caused deflation.
Decades of Government Control: During the 1930s to 1960s period, the great depression happened and the breakdown of the gold standard exhibited huge failure for central banks and the government took control of policies. Socialist control by government got high importance for by the requirement of resources for WWII. The government’s role in taking over monetary policy was a practical necessity. There was continued depression and deflation and government pushed for low interest rates and after the gold standard fell apart – for devaluation. In WWII times, direct rationing by governments was carried out. Interest rates were set by government, hence monetary policy as well. This was less the situation in countries like Germany, Switzerland and USA where central bankers had some say in monetary policy setting and more so in other countries