Wednesday, October 13, 2010

What do Central Banks do?

I'm lecturer for second term (econ101b), which is macroeconomics. Currently Martin Jensen is lecturing you on microeconomics, and so when I post I'll be pointing you towards macroeconomic events and news and how that links in to what we'll look at next term.

One thing we'll ask next term is: What do Central Banks do? They are always in the news, particularly around Monetary Policy Committee (MPC) meeting times in the UK. The Bank of England is the Central Bank for the UK. In the US, a system called the Federal Reserve System operates in place of a single Central Bank, and there are Federal Reserves of a number of regions in the US - Minneapolis, New York, Philadelphia, San Francisco, etc. But they all hang together under the Federal Reserve, naturally headquartered in Washington. Their equivalent of the MPC called the FOMC, or the Federal Open Market Committee.*

But what do these Central Banks actually do? Generally they are given responsibility for monetary policy in most economies: The MPC sets interest rates to achieve an inflation target, the idea being that if inflation is kept low and stable, the macroeconomy will stay roughly in order. In the US, the objective of the Federal Reserve is a little wider than just inflation and includes the wider macroeconomy.

There have been many criticisms over the years about whether targetting is the right thing: What's the right target? Why just inflation? Why not asset prices? What is the effect of different targets? An alternative school of thought, pushed more than most by an economist called Scott Sumner, is that Central Banks should target nominal GDP (that's GDP in the actual prices we pay before any correction is carried out for inflation).

It turns out that in its most recent meeting the FOMC hinted it may well begin such a targetting exercise. Next term we'll consider much more what this actually means, other that at the basic level it means that the Federal Reserve would target a particular level of nominal GDP (NGDP) and hence choose interest rates and other monetary tools in order to achieve this aim, just like currently the Bank of England chooses interest rates to achieve 2% inflation.

*: Despite the prevalence of Wikipedia links in this post, the advice is: Don't rely on Wikipedia. Anyone can edit it and hence put false information in there. Rely instead, if you need to for referencing, on something like the New Palgrave Dictionary of Economics. If you refer to Wikipedia in any assignments you hand in, you'll likely incur the wrath of your tutor!

No comments:

Post a Comment