Challenging the Contemporary Role of Central Banks

Written by Siyaduma Biniza*

The role of central banks is focused on inflation-targeting and currency protection. This

is quite different from the historical role of central banks which was more extensive and

developmental focused. This changing of the role of central is firstly a consequence of

the international dominance of neoliberalism. Secondly, this changed role is

characteristic of a deeper ideological and scholarly disjuncture on the growth and the

efficiency of markets. This disjuncture is mostly characterised by mainstream and

heterodox views on growth and inflation. The mainstream view is that central banks

can only pursue economic growth at the cost of inflation. Whereas, the heterodox view

is that central banks can pursue economic growth whilst avoiding hyperinflation.

Considering these aspects of the current role of central banks this paper discusses

whether central banks should focus on inflation of support employment and economic

development.

Early central banks in now developed countries typically evolved from private banks

that were granted access to subsidised credit in return for performing some functions.

Some of these functions include issuing national currency, being a commercial and a

state bank, being the lender of last resort, providing monetary policy to maintain

foreign reserves, price level, and economic activity, and offering credit towards state

objectives (Epstein, 2007). Moreover, central banks historically played distributive,

political and allocation roles (Epstein, 2007). This means that central banks can affect

the class distribution in an economy. Central banks also played an integral role in

strengthening currencies and sovereignty (Epstein, 2007). Thus, central banks

historically had a far more extensive role.

However, the role of central banks has changed dramatically. The purposes above,

which are direct uses of central bank policy for macroeconomic outcomes, have

changed to more indirect uses of central bank policies through macroeconomic

fundamentals (Epstein, 2005). Therefore central banks now practice monetary policy

that targets macroeconomic objectives through fundamentals such as interest rates,

inflation and money supply. These policies are intended to achieve macroeconomic

goals such as promoting economic growth through indirectly means such as the

impact of these fundamentals on investment. Thus the current approach emphasises

the reliance on market mechanisms which is seen as the best practice for central banks

(Epstein, 2005).

This evolved role of central banks that has resulted in central banks orientation

towards markets is a consequence of the dominance of neoliberal economics. Firstly

central banks have come under the influence of institutional reform associated with

credibility policy. This means that central banks have had to undertake certain policy to

fit into the criteria of credible policies that are aligned with investment and the possibly

resulting economic growth. In other words, over the Washington Consensus era, which

led to the reduction of the role of the state, the independence of central banks has

increasingly become a prerequisite for the credibility of monetary policy which is

necessary for investor confidence (Grabel, 2000). This separation of the central bank

from the state and politics has reformed central banks into inherently neoliberal

institutions. The result has been the dissolution of central banks historically political

role through the use of central bank independence as a criterion for policy credibility;

which is often used as precondition for private investment. This has become the first

tenet of central banks best practice amongst with other characteristics that fit within

the neoliberal agenda.

Associated with this is the emphasis on inflation-targeting. In developing economies,

the World Bank (WB) and International Monetary Funds (IMF) have been the stalwarts

of this narrowing of central banks prerogatives (Grabel, 2000). Following economic

crises these international financial institutions would impose economic programming

in return for financial assistance to developing economies in distress. Together with the

independence requirement, the IMF and WB would orchestrate institutional reform in

central banks through educating central bank authorities in best practices which

emphasised a focus on inflation fighting (Grabel, 2000). Inflation-targeting and other

neoliberal policies that constituted the structural adjustment packages were often

taken as a prerequisite for economic development and recovery in many developing

economies (Epstein, 2005). Yet none of these policy packages have resulted in

favourable macroeconomic outcomes in the developing economies.

Nevertheless, inflation-targeting was again reinforced through the credibility theory

which often associated policies that served the interest of private investors with

policies that would lead to economic development and growth (Grabel, 2000). Hence,

the adoption of rule-based practices such as inflation-targeting, which serves the

interest of private investors, has been reinforced as a required policy for economic

development and growth. Thus, inflation targeting was used a requirement for credible

macroeconomic policies that would attract private investors towards developing

economies. Again, this is characteristic of the dominance of neoliberal economics. But

this is also characteristic of a deeper underlying ideological battle about the impact of

inflation on economic growth.

The theoretical foundations of inflation targeting originate from a seminal speech by

Michael Friedman. Friedman (1968) argued that monetary policy cannot be used to

control interest rates for any extended time-period nor can it be used to control the

unemployment rate for any extended time-period. According to Friedman, the

mechanisms through which monetary policy can affect both interest and

unemployment rates have been misunderstood. The misunderstanding stems from a

conflation between real and nominal quantities and analyses that are not time-

sensitive (Friedman, 1968).

So the central bank controls only nominal quantities, i.e. its liabilities in the form of

bonds, and it cannot control real quantities such as the real interest or unemployment

rates, real GDP, real growth rate or the real growth rate of the quantity of money

(Friedman, 1968). These real quantities are consequences of immediate and delayed

consequences of monetary policy. Thus, although monetary policy can affect these

quantities it cannot control them and it can only influence the real quantities in the

short run (Friedman, 1968).

This means that monetary policy can be used to curb economic shocks (Friedman,

1968). Therefore, monetary policy can be used to affect nominal interest rates which

are useful as an economic incentive for certain economic activity such as saving or

holding money. This means that in cases of lack of confidence in the banking or

financial system, the central bank can adjust expectations by manipulating the nominal

interest rate or the nominal quantity of money in the economy; to induce saving or

stimulate spending.

Secondly, monetary policy can be used as a backbone for economic stability. Monetary

policy can affect the stability of prices which signals and reinforces the stability of the

economy allowing for greater economic activity. Stability of prices of prime importance

for most economy activity in a capitalist system; but this is only useful as a way of

affecting preferences for technological and spending changes (Friedman, 1968).

Lastly, monetary policy can be useful in offsetting major economic shocks that arise

from non-monetary sources (Friedman, 1968). For example monetary policy can be

useful to offsetting major inflation as a result of unrestrained government spending

and a rising budget deficit. Monetary policy can be used to induce reduced spending

and increased savings or debt-servicing. Thus, monetary policy can be used to control

the extent of nominal quantities, as a backbone for economic stability and to curb

major economic disturbances.

The significance of Friedman on the direct and content of the debate on the role of

monetary policy and central banks is clear given this summary of his contribution. This

is why the focus of central banks has been on price stability since Friedmans work

convincingly argued that monetary policy cannot affect things like long-term growth.

Therefore, the mainstream approach has become an understanding of the impact of

monetary policy that is consistent with the Phillips curve. The idea is that central banks

should only concern themselves with short-term economic stability which is done

through nominal quantities such as the interest rate. The assertion is that central banks

can influence aggregate demand through interest rate which affects consumers

liquidity preferences. In other words, if there is low aggregate demand and high

unemployment, the central bank can reduce the interest rate which increases the

demand for money. This would affect consumers liquidity preferences in that the cost

of borrowing would be cheaper and the demand for money would increase whilst the

demand for assets such as bond decrease; this would result in higher aggregate

demand which can decrease unemployment in the short-run (Friedman, 1968).

However in the long-run, when prices can adjust to the changes in aggregate demand,

the result would be that aggregate demand increase only relate to increases in price

levels which does not result in any changes in unemployment (Friedman, 1968).

Thus, the mainstream conclusion is that growth only occurs at the cost of inflation in

the long-run. This makes it seem as though growth and inflation are incompatible and

that monetary policy that pursues targets besides inflation would only lead to some

growth in the short-run at the cost of inflation; which is seen as inimical to economic

growth. Moreover, the assumption is that growth, unemployment and reduction in

poverty will be an automatic consequence of macroeconomic stability which is

reduced to price stability (Epstein, 2007).

But empirical evidence shows that different policy recommendations can be made

when we separate between levels of inflation. A study by Bruno and Easterly shows

that, if we separate between normal inflation and hyperinflationary, the relationship

between inflation and growth is less determinate. For low inflation there is an

indeterminate relationship between inflation and economic growth (Bruno & Easterly,

1998). But growth cannot be sustained under hyperinflation (Bruno & Easterly, 1998).

This means that growth can be achieved with inflation whilst avoiding hyperinflation.

This is the heterodox view that central banks can pursue economic growth whilst

avoiding hyperinflation. At low to moderate level of inflation the negative association

of inflation and growth are not as robust (Bruno & Easterly, 1998). This discredits the

mainstream view that is built on the premise that inflation is inimical to growth and

that central banks should only pursue inflation-targeting to avoid the negative impact

of inflation on economic growth. However, the mainstream thesis is true when we look

at hyperinflation such growth cannot be sustained with high levels of inflation. The

consequence of this is that the best practice of central banks, which is a fundamentalist

pursuit of price stability, is unfounded and that this might actually be at the expense of

growth.

Furthermore, even though macroeconomic stability is a necessary condition for

sustained economic growth, price stability is not the only way to pursue

macroeconomic stability. The narrow view of what constitutes macroeconomic stability

is unfounded given the indeterminate relationship between growth and low to

moderate levels of inflation. This suggests that certain levels of inflation might

conducive to economic growth. Moreover, central banks should be blindly pursuing

economic growth through inflation-fighting when inflation can actually stimulate

economic growth. Thus central banks should not just pursue inflation targets at the

expense of growth. Moreover, given that employment and poverty reduction are also

vital towards macroeconomic stability, central banks should expand their mandate in

co-operation with governments to include such objectives and move away from

financial conservatism; if their main purpose is to stimulating economic growth and

development (Sen, 1998; Epstein, 2007).

But a relaxation of central bank policy or the extension of central banks mandates is

unlikely given the dominance of neoliberalism which throttles economic growth with

its independence requirement on central banks and the best practices of inflation-

fighting. This is because; the use of credibility theory which reinforces the neoliberal

agenda has been enshrined through best practice rules, legislation and even national

constitutions at times (Grabel, 2000). But the fortunate misfortune of financial

instability, which is a greater threat to economic growth than inflation, is that recent

financial crises have exposed the short-comings and inadequacy of markets. Hopefully

this will result in a better understanding of the role that central banks can play given

that recovery from the crisis became the prerogative of central banks worldwide; which

has increased the scope of central banks economic tools.

Bibliography

Bruno, M. & Easterly, W., 1998. Inflation Crisis and Long-Run Growth. Journal of

Monetary Economics, 41, pp.3-26.

Epstein, G., 2005. Central Banks as Agents of Economic Development. Working Paper

Series No. 104. Amherst: Political Economy Research Institute University of

Massachusetts Amherst.

Epstein, G., 2007. Rethinking Monetary and Financial Policy: Practical Suggestions for

Monitoring Financial Stability While Generating Employment and Poverty Reduction.

Employment Working Paper No. 37. Geneva: International Labour Organization

International Labour Office, International Labour Organization.

Friedman, M., 1968. The Role of Monetary Policy. American Economic Review, 58(1), pp.1-

17.

Grabel, I., 2000. The Political Economy of 'Policy Credibility': The New-Classical

Macroeconomics and the Remaking of Emerging Economies. Cambridge Journal of

Economics, 24, pp.1-19.

Sen, A., 1998. Human Development and Financial Conservatism. World Development,

26(4), pp.733-42.

* Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.