Changing Role of Central Bank

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ISSN 1359-9151-197 The Changing Role of Central Banks By C.A.E. Goodhart SPECIAL PAPER 197 LSE FINANCIAL MARKETS GROUP PAPER SERIES December 2010 Charles A. E. Goodhart is Director of the Regulation and Financial Stability Research Programme at the Financial Markets Group and Professor Emeritus of Banking and Finance at the London School of Economics. Any opinions expressed here are those of the author and not necessarily those of the FMG. The research findings reported in this paper are the
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     ISSN 1359-9151-197  The Changing Roleof Central Banks   ByC.A.E. GoodhartSPECIAL PAPER 197 LSE FINANCIAL MARKETS GROUP PAPER SERIES December 2010 Charles A. E. Goodhart   is Director of the Regulation and Financial Stability ResearchProgramme at the Financial Markets Group and Professor Emeritus of Banking and Finance atthe London School of Economics. Any opinions expressed here are those of the author and notnecessarily those of the FMG. The research findings reported in this paper are the result of theindependent research of the author and do not necessarily reflect the views of the LSE.  The Changing Role of Central Banks By C.A.E. GoodhartFinancial Markets Group, London School of EconomicsAbstractAlthough Central Banks have pursued the same objectives throughout their existence,primarily price and financial stability, the interpretation of their role in doing so hasvaried. We identify three stable epochs, when such interpretations had stabilised, i.e.,a)   The Victorian era, 1840s to 1914;b)   The decades of government control, 1930s to 1960s;c)   The triumph of the markets, 1980s to 2007.Each epoch was followed by a confused inter-regnum, searching for a new consensualblueprint. The final such epoch concluded with a crisis, when it became apparent thatmacro-economic stability, the Great Moderation, plus (efficient) markets could notguarantee financial stability. So the search is now on for additional macro-prudential(counter-cyclical) instruments. The use of such instruments will need to be associatedwith controlled variations in systemic liquidity, and in the balance sheet of the CentralBank. Such control over its own balance sheet is the core, central function of anyCentral Bank, even more so than its role in setting short-term interest rates, whichlatter could be delegated. We end by surveying how relationships between CentralBanks and governments may change over the next period.1  1. Historical IntroductionCentral Banks have generally had three main objectives or functional roles. Thesehave been:-i)   To maintain price stability, subject to the monetary regime in currentoperation, for example the gold standard, a pegged exchange rate or aninflation target;ii)   To maintain financial stability, and to foster financial development morebroadly;iii)   To support the State’s financing needs at times of crisis, but in normal times toconstrain misuse of the State’s financial powers. In the past this meantpreventing debasement and misuse of the inflation tax. Prospectively it mayin future also involve preventing misuse of the bank tax.Naturally the balance between these three objectives has shifted over time, withsupport for state financing becoming prominent during war-times. Indeed, several of the first Central Banks to be established, notably the Bank of England and the Banquede France, were founded to help provide war finance. But, absent wars, it is theshifting balance between the Central Bank’s monetary policy (stable prices) and itsfinancial stability role that usually generates most interest. In this latter respect, wemay perhaps identify three main stable epochs from the past, with shortish periods of confusion and searching for a new regime/system in inter-regnums between them.These three periods are (a) the Victorian era, say 1840s until 1914; (b) the decades of government control, 1930s until the end of the 1960s, and the triumph of the markets,2  1980s until 2007. The period 1914-1931/33 was a confused inter-regnum includingWWI, followed by a failed attempt to re-establish the Gold Standard (Eichengreen,Golden Fetters, 1992). Similarly the 1970s was another confused inter-regnumbetween the subservience of monetary policies to government control, and theestablishment of a free market system, with the Central Bank following a regime of inflation targetry.Following the on-going financial crisis, Central Banks are now probably on the vergeof a further, fourth, epoch, though the achievement of a new consensus on theirappropriate behaviour and operations may well be as messy and confused, as in thetwo previous inter-regnums. But if we want to know where Central Banking may beheading, it is as well to have a good understanding of where we have been, since ourhistorical record provides our only empirical evidence.A. The Victorian Era: In Praise of the Real Bills DoctrineThe main concern of the great monetary writers of the Victorian age, notably HenryThornton and Walter Bagehot, was how to reconcile adherence to the Gold Standardwith the maintenance of financial stability, especially at times of panic and stress.[Though the Bank of England was also much concerned about the opposite problemof how to make Bank Rate effective in times of confidence and expansion.] Theanswers that came forth mostly took the form of certain rules of thumb, notably thePalmer rule for varying Bank rate (named after Governor Horsley Palmer of the Bank of England, which may, with the eye of faith, be seen as a kind of prototype Taylor3
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