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!

Policy Uncertainty

One thing we'll talk about second term is the impact uncertainty can have on economic outcomes.  In other words, if people are uncertain, they do less: They don't take big decisions.  In particular, they don't make investment decisions.

A big thing in the US currently is the impact of uncertainty over government policy, and its impact on the economy.  Tyler Cowen at Marginal Revolution (a blog well worth subscribing to for both terms of your econ101 experience) has this post about it.  Some people suggest that uncertainty over policy is the reason why the US economy is not recovering strongly.  These people are generally Republicans responding to the fact they are out of power and trying to lay all the blame at the foot of the in-power Democrats.

As Cowen points out though, there's much more at stake - not least the restructuring that's going on in the US economy.

The main point I think is: Don't trust anyone who tries to tell you there's a single cause for why the economy is in the mess it's in, either this side of the Atlantic or the other.  There's many, many causes, and a huge number of alternative solutions out there that may or may not work.  The economy is a complicated beast, and far too complicated for single-cause explanations...

The Austrians

A fairly non-mainstream school of thought in economics is the Austrian School of Thought.  Austrians emphasise the price mechanism and its supremacy: Left unconstrained it leads to the best possible allocation of resources.  It may be that the market doesn't lead to be the optimal allocation, distortions are possible; but government intervention won't be helpful - the "dead hand" of government will always lead to a worse outcome.

As a result, an Austrian economist probably doesn't like very much the actual Austrian, or continental European, economic systems - social democracies with high taxes and heavy government intervention in markets.

Funny then that this Austrian economist, Don Boudreaux, seems to be gloating about strong growth in Germany vs the US.  Germany has just reported 2.2% GDP growth last quarter (which is impressive), while the US appears to be toiling towards a double dip recession.

Germany also has been embracing austerity recently, with significant spending cuts to address its large budget deficit, while the US, via Obama and the Democrats, is about the only major economy still attempting to pursue fiscal stimulus policies to encourage economic growth.

So the fact that the US, maintaining strong government intervention, is muddling towards a double dip recession, while Germany, cutting it back, has reported strong growth, is music to this Austrian's ears.

Of course, the story is so much more complicated than that.  Not least: You can't prove anything with one data point.  Then: How quickly do fiscal policies have any effect?  Finally, what is the impact of government intervention in the macroeconomy?  (the answer is it's quite slow with time lags, so the current numbers have nothing to do with recent decisions on austerity vs stimulus spending).

All these things you'll learn more about second term next year when we get to macroeconomics in the econ101 course.