The Key Roles of Central Bank - Assignment Example

The Key Roles of Central Bank By + Examine the key roles of the central bank in an economy. Why isthe lender of last resort function controversial? Introduction The central bank plays a major role in stabilizing an economy. There are different macroeconomic instruments that the central bank can implement to affect the economic state of a nation. However, there exist different arguments on the involvement of the central bank in some economic and financial areas. This paper explores different areas that the central bank controls, including intervention in the foreign exchange market, implementing monetary policy, regulation of the financial sector, and the last lender resort role of the central bank. Before engaging in the discussion, it is important to note that the role of the central bank and the extent of its involvement may vary according to the presence of different stakeholders and varying legislations. For instance, the US central bank does not regulate the financial sector while on the other hand other governmental parts have to approve the intervention measures of Japan’s central bank. This paper outlines the importance of publications of the central bank and related forecasts of the macroeconomic trends of an economy. The paper shows that information and views of the central bank are important to stakeholders such as forecasting agencies and market players. Macro-economic Stabilization Different economists agree that the pivotal role of the central bank is macroeconomic stabilization. The macroeconomic stabilisation role involves the central bank keeping in check the exchange rate, price levels, and payment systems in the domestic market. Overdependence on business cycles as well as operations of multinational enterprises in the domestic market may pose a serious financial threat to an economy. These factors may distort prices, including foreign exchange rates and interest rates, which can create insolvency, severe fluctuations, and disruption of the domestic economy. For an economy to achieve economic development there has to be financial stability otherwise, the economy will become fragile, reduce agent’s confidence, and cause moral hazards. The lack of financial stability leads to borrowers obtaining lower wealth than normal proceeds from an investment project. On the other hand, low agent confidence and the unpredictability of future trends may bore higher agency costs and undermine the performance of the investment sector. Driffill et al (2003) agree that financial stability and monetary policy go hand in hand. Driffill et al (2003) base this argument on the fact that the activities of the central bank aim at stabilising price fluctuations and smoothing interest rates, which is critical in achieving stability without causing disruptions on the market equilibrium. Beine & Bernal (2005) argue that a central bank may adopt two approaches in the stabilisation of the foreign exchange rates. These approaches are open intervention and secret intervention. These approaches can be implemented to counter negative trends in foreign exchange trades. Countries avoid sending the wrong signals to other market agents by applying secret intervention. Market agents closely monitor the activity of the central bank and make forecasts depending on the level of consistency of the data and information provided by the central bank. Any controversy between an intervention and previous policies of the central bank may confuse market players and cause distortions in the market. Some of the distortions that could arise include higher degree of information asymmetry between agents and high fluctuation of rates. Therefore, it is paramount that the Central Bank implements stabilisation measures that are in line with market expectations. Failure to consider market expectations may lead to serious market failures. Central Bank Publications and forecasts Publications and forecasts by the Central Bank are important in an economy. Many forecast agencies use the information available on Central Bank publications and forecasts to adjust their predictions. Geraats (2002) argues that economic agents do not have the wealth of information that a Central Bank can accumulate. Carroll (2003) argues that most market agents form rational prospects based on forecasts by professionals. On the other hand, professional agents rely on data in Central Bank publications to make forecasts on the future directions of the markets. Market players barely know the information that is processed by the Central Bank regarding future economic development (Romer & Romer 2000). As such, predictions by market agents on future development of the economy are based on asymmetric information. Therefore, publications by the Central Bank help in reducing information asymmetry and guides market agents in making fair predictions about the future development of the economy. Geraats (2002) states that publications by the Central Bank indicate the Central Bank’s view point of the country’s macroeconomic situation. Market agents can use the Central Bank’s viewpoint to predict possible interventions by the Central Bank. The economic agents can use this information to adjust their tactics accordingly. However, it is important to note that the market agents will only adjust their strategies if they are rational and the Central Bank is consistent in its publications and forecasts. Rational expectation is only possible if the Central Bank and other governing authorities are consistent in their activities and have a satisfactory public credibility (Huanga & Weib 2005). In developing economies and economies in transition, the Central Bank may lack credibility because of corruption, weak governmental institutions, and macroeconomic instability (Huanga & Weib 2005). Geerats (2002) argues that issues of credibility and transparency of the Central Bank’s forecasts is crucial in any economy. Transparency here entails the lack of asymmetric information between economic agents and monetary policy makers (Geerats 2002). Transparency and provision of consistent and credible information eliminates heterogeneous behaviour, which may arise from differing expectations among agents about the future macroeconomic development. Different countries such as Canada, Sweden, and the UK implemented new approaches to increase the degree of transparency, known as explicit inflation targeting. The Central Banks of other countries such as Japan, the United States, Switzerland, and Brazil have also adopted the explicit inflation targeting. Concerning the credibility of publications and forecasts by the Central Bank, Cechetti & Krause (2002) argue that this information creates an appropriate set of expectations about the development of the economy and reduces the uproar that may come from Central Bank’s activities and interventions. This is implies that the Central Bank is tasked with providing information that creates a portfolio of expectations, in the process enabling rational economic agents to react accordingly to that information. Consequently, the Central Bank can predict the response of some market agents and be able to plan its policy in view of that. Additionally, consistent information from publications by the Central Bank helps in promoting efficiency in the markets. Regulation and Monitoring In many countries, the central bank combines the functions of macroeconomic stabilisation with financial system management (Ioannidou 2003). In transition economies, the Central Bank is the backbone of the financial system and combines both macroeconomic stabilisation and control of the developing financial system. Debates continue to emerge on such combination roles that the Central Bank plays in an economy. Comparative studies show that the macroeconomic decisions of a Central Bank may be affected by its engagement in managing the financial system due to a conflict of interest (Heller 1991). For instance, desire for a certain interest rate by the Central Bank to resolve exchange rate issues or inflation rate issues may violate the profitability policy in the banking sector. This effect arises from the nature of activities in the banking sector, which is, borrowing in the short period and lending in the long periods. Banks may suffer from the bad effects of high interest rates on the solvency. A modern day examples of the adverse impact of Central Banks combining macroeconomic stabilisation with management of the financial system is the 1998 crisis in Russia. In the build up to the crisis, the Central Bank was involved in the management of the financial system in the process undermining its forethought on the macroeconomic front, which resulted to the extensive financial crisis that hit the Russian economy. The Russia crisis served as a warning shot to other economies, which reacted by restricting the role of the central bank. Policy makers in Japan, the UK, and other countries released their Central Bank from its role of supervising banks. In order to avoid conflict of interest, the European Central Bank was not given any supervisory responsibilities (Ioannidou 2003). According to Goodhart & Schoenmaker (1992), the different nature of the monetary and regulatory functions brings about conflict of interest between different roles of the Central Bank. The regulatory role of the Central Bank may require the implementation of short-term microeconomic decisions. Contrary, macroeconomic functions are long run in nature and may result in short-term losses. According to Ionnidou (2003), the impacts of supervision and regulation tend to be pro-cyclical while the monetary policy is normally counter-cyclical. Therefore, the regulation and supervision role of the Central Bank may offset the aims of the monetary policy. Credibility is another negative impact of the Central Bank combining different duties. Banks may be held responsible for occurrence of failures even though the Central Bank holds responsibility for bank control and monitoring. As such, market agents may end up losing their trust in that bank even though the Central Bank is responsible for the market failures. Last Lender Resort Some scholars believe that the Central Bank played the role of last lender resort by tradition. Both Gerdrup (2005) and Humprey & Keleher (2002) agree that the prospective risk of disruption of the banking system reduces when the Central Bank acts as the last lender resort. In some instances, market failures and interest rate fluctuations may create insolvency problems where one bank may be incapable of meeting its obligations in intra-bank activities. The problem of insolvency may spill over from one bank to another and in the process affect the whole banking system. Additionally, Driffill et al. note that last lender resort activities may offer excessive support to banks, which may prompt a form of moral hazard. This situation relates to the case of US banks, where commercial banks may expect too much favourability from a stable macroeconomic climate and the support of the Central Bank. Because of too much expectation, the banks may ignore existing market risks and commit to risky portfolios of deposits and loans. Subsequently, the fluctuation of the exchange rate may create a problem of insolvency leaving the Central Bank with the burden of bailing out banks that fall in the trap. This situation poses a threat to the macroeconomic stability of an economy. In case of a massive insolvency in the banking sector, the Central Bank may be incapable to cover all the insolvency problems, which might lead to a breakdown of the financial system and eventually an economic crisis. In order to avoid the occurrence of such a scenario, the Central Bank warns financial market participants in advance about its ability to act as last lender resort (Driffill et al. 2003). Therefore, banks and other financial institutions are required to adopt a risk adverse approach in periods of high fluctuations in interest. Borchgrevink & Moe (2004) advocate for the Central Bank to implement a close monitoring of the risk management policies of banks and other financial institutions. Some countries have implemented different measures to ensure that financial institutions adhere to a set of risk management policies. For instance, in Norway, the Central Bank works in partnership with the Financial Supervisory Authority to monitor activities of banks and other financial institutions (Gerdrup 2005). In this partnership, the Financial Supervisory Authority is empowered to intervene if it foresees that the activities of a given financial institution may pose a threat to the economic stability of Norway. According to Borchgrevink & Moe (2004), for market agents to be more prudent, there is need for the Central Bank to limit its last lender resort activities. Contrary, Driffill et al. (2003) argue that the fact that banks borrow short and lend long makes it difficult to predict some risks. As such, Driffill et al. (2003) note that any sudden inflation scare may cause drastic short-term change of rates in the process inducing a tight monetary policy and result in insolvency problems for some banks. Conclusion This paper defined the role of the Central Bank and the level of its engagement in the micro and macroeconomic development of an economy. The paper highlights the importance of the Central Bank, which is responsible for the macroeconomic stabilisation of an economy by intervening in the foreign exchange market and adjusting interest rates. These functions mitigate the distortion of the economy and minimize negative effects that may arise from the activities of both local and global market agents. The paper also discusses Central Bank’s role of disseminating economic forecasts about future economic development. An in depth insight into this role revealed the need for the Central Bank to extensively engage in collecting market information. The data on economic trends, business cycles, and other indicators of economic development are important as they form a basis for the Central Bank to process future forecasts, formulate its policy, and share the information with market players. By availing the information to market agents, the Central Bank not only helps in minimising information asymmetry among market players but also establishes a foundation to implement and make its procedures more effective. This paper also discussed the regulatory and monitoring function of the Central Bank. An insight into the views of different scholars revealed that the Central Bank is in a position where it can influence the development of an economy’s financial system. However, engaging in the management of the Central Bank may result in conflict of interests, which can affect the forethought of the Central Bank and hinder its role of macroeconomic stabilisation. This explains why developed countries tend to alienate the regulatory function from the Central Bank. This paper also discusses Central Bank’s role of last lender resort. The paper explains conditions where the Central Bank becomes the last minute resort for banks and other financial institutions that face insolvency problems. The central Bank intervenes and bails out financial institutions trapped in insolvency problems and in the process help prevent the crisis from spreading to other market agents. The paper also emphasized on the significance of prudential approach while outlining the adverse effects that excessive support poses on the financial system. Bibliography Beine, M., & Bernal, O. (2005) Why do central banks intervene secretly? Preliminary evidence from the BoJ. Journal of International Financial Markets, Institutions, and Money. Beine, M., Bénassy-Quéréc A., and MacDonald, R. (2005). The impact of central bank intervention on exchange rate forecast heterogeneity. 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