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A solution to homework assignment 12 for econ 353 money, banking, and financial institutions course in spring 2006. It covers topics such as the damaging effects of inflation on an economy, the impact of electronic money on central bank's ability to control inflation, the advantages of explicit versus implicit price stability goals for central banks, arguments in favor of central bank independence, and the effects of foreign exchange transactions on central bank's balance sheet.
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Econ 353 Money, Banking, and Financial Institutions Spring 2006 Dzmitry Asinski
Homework Assignment 12 solution.
High level of inflation creates risk – it is typically more difficult to predict what the actual inflation will be in the future if one expects inflation to be high (e.g., if the expected inflation is 15% it wouldn’t be unusual to observe the actual inflation of 20%, whereas it would be unusual to observe 7% inflation if the expected level is 2%). The inflation risk is systemic and therefore not diversifiable. In addition, constantly changing prices reduce the effectiveness of money as a store of value (people would prefer to hold other assets). Money can even lose its ability to perform the role of a means of payment if the inflation is very high (hyperinflation)
The ability of a central bank to control inflation ultimately depends on its ability to control the amount of money in circulation. Central banks have considerable amount of control over the amount of money in their respective economies because they have monopoly over printing currency and creating reserves (this control is not perfect, especially in more developed countries). At the same time central banks do not have any control over electronic money (electronic money is not issued by central banks) so their ability to manage inflation are diminished because of the spread of electronic money.
A central bank that sets explicit objectives (like target level of inflation) is clearly more transparent and accountable. This strategy gives credibility to the central bank itself and its policies. Credibility reduces risk – if a central bank says that the inflation will be between 1 and 3% and the inflation always is between 1 and 3%, market participants will tend to believe statements made by the central bank. If a central bank never promises or (worse) promises but never delivers on the promises, there would be no reason to expect that inflation will fall between 1 and 3%. If inflation is less predictable – there is more risk.
The advantage of not defining explicit goals is that there may be situations where (1) it is not possible to achieve these goals (and it is much worse not to be able to achieve an explicitly stated goal than not to state any goals at all), (2) it is desirable to have higher inflation (to stimulate growth, for example). A central bank without explicit goals has more flexibility and can potentially address multiple objectives.
The main argument for central bank independence (from elected politicians) is that politicians are typically concerned with short-term outcomes (which decide elections) and not long-term outcomes (which are more important). For example, it may be possible to achieve short-term growth by pumping money into the economy (and win the elections). The long-term consequences of this (inflation) may not surface until after the politicians are safely in their seats. On top of that, politicians are typically not trained to conduct complex monetary policies.
The monetary base is equal to the sum of currency and reserves. The impact of this transaction is shown on a T-account below (wasn’t required for this problem):
A | L Foreign exchange | Reserves +$1 bln Reserves +$1 bln |
The monetary base goes up by $1 bln. To keep the monetary base unchanged Fed could sell some securities (T-Bonds):
A | L Securities -$1 bln | Reserves -$1 bln
To the Central Bank of China US dollars are foreign currency:
A | L Foreign exchange | Reserves +$1 mil Reserves +$1 mil |