Tuesday, September 22, 2009

The goals and channels of central banking

Central banking is goal oriented. Since World War II the United States and several other industrialized nations have accepted the premise that government is responsible to its citizens for maintaining high levels of employment, combating inflation, and supporting sustained economic growth. This is a relatively new idea since, in earlier periods, governments were assigned a much smaller role in the economic system and much less was expected of them by their citizens. It was felt that "automatic" mechanisms operated within t economy to provide stability and high employment in the long run. One of the bitter lessons of the Great Depression of the 1930s was that these mechanisms can break down and that innovative and skillfully managed government policies may be needed to restore the economy's stability and growth.
Central banking in the United States and in most other nations is directed toward four major goals:
1- Full employment of resources.
2- Reasonable stability in the general price level of all goods and services.
3- Sustained economic growth.
4- A stable balance of payments positions for the nation vis-à-vis the rest of the world.
Through its influence over interest rates and the growth of the nation's money supply, the central bank is able to influence the economy's progress toward each of these goals. Achievement of all these goals simultaneously as proven to be exceedingly difficult, however, as the recent track record of the economy demonstrates. One reason is that the goals often conflict. Pursuit of price stability and an improved balances of payments position, for example, may require higher interest rates and restricted credit availability- policies which tend to increase unemployment and slow investment spending and growth. Central bank policy making is a matter of accepting trade-off (compromises) among multiple goals. For example, the central bank can pursue policies leading to lower rate of inflation and a stronger dollar but probably at the price of some additional unemployment and slower economic growth in the short run.
Central banking in most Western nations, including the United States, operates principally through the marketplace. Modern central banks operate as a balance wheel in promoting and stabilizing the flow of savings from surplus-spending units to deficit-spending units. They try to assure a smooth and orderly flow of funds through the money and capital markets so that adequate financing is available for worthwhile investment projects. This means, among other things, avoiding panic in the market due to sudden shortages of available credit or sharp declines in security prices. However, most of the actions taken by the central bank to promote a smooth flow of funds are carried out through the marketplace rather than by government order. For example, the central bank may encourage interest rates to rise in order to reduce borrowing and spending and combat inflation, but it does not usually allocate credit to particular borrowers. The private sector, working through demand and supply forces in the marketplace, is left to make its own decisions about how much borrowing and spending will take place at the current level of interest rates and who is to receive credit.

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