Tuesday, June 24, 2008

The Role of the Central Bank

What is the role of the central bank, anywhere in the world?

The first central bank in the world is the Bank of England, originally created in 1694 to finance war for the king. The US Federal Reserve was established to prevent another depression similar to the one in the 1930s as a result of unbridled monetary expansion which led to the stock market crash of 1929 - although Mr. Alan Greenspan would have read the other interpretation that the depression was caused by too tight a monetary policy when the market crashed. The German Bundesbank, in the aftermath of the 1920s hyperinflation after WWI, vowed to fight inflation all the way. (New Zealand today requires the central bank to target inflation at the 1-3% range over the medium term.)

Milton Friedman said about monetary policy, "You cannot push a string, but you can pull it."

Monetary policy cannot stimulate economic growth - only innovation and investment can, by keeping monetary growth just enough to finance investment. Keeping the interest rate low is to say that the central bank is willing to finance investments with poor returns.

An easy monetary policy stimulates inflation - domestically by keeping demand unusually high. It also encourages speculation in the stock market and the real estate market with a negative real interest rate where the nominal interest rate is lower than asset inflation so that it pays to borrow money from banks and speculate.

Externally, an easy monetary policy with a low interest rate encourages "external inflation" by allowing the currency to depreciate so that imported inflation is higher.

While the government spends through deficit spending, the role of the central bank must be to control the money supply so that inflation does not become a major problem. The Minister of Finance is not the Governor of the Central Bank, and must not be allowed to do the other's job.

The role of the central bank must be to contain inflation (including asset inflation) in order to protect the underlying long-term growth potential of the economy.

It is sad in Malaysia today that investment has given way to speculation, seriously undermining technical knowledge and innovation, as a result of a loose monetary policy on a sustained basis.

1 comment:

Jeremiah said...

Allow me to quote from my blog on this issue: www.jeremiahliang.blogspot.com:

"Bank Negara should educate the public about the linkage between cost-push inflation and demand-push inflation. BN always say the two types of inflation are different but the truth is that cost-push can lead to demand-pull when expectations are anchored that food and oil prices will continue to rise. The worst type of inflation is galloping inflation caused by the people's diminishing faith in the Ringgit.

5. That the real reason for rising inflation (not the national average CPI) is partly because there is excess money in the system created by a managed currency policy. 101 Economics tells you that too much money chasing after too few goods leads to higher prices. Hence, letting the Ringgit appreciate will curb money creation and dampen inflation.

In conclusion, good inflation (e.g. 3%-4%) occurs when prices rise due mainly to higher costs and there is little people can do anything about it except to buy less of the item and switch to a cheaper subsitute. Bad inflation (e.g. 4%-7%) occurs when prices rise due to higher consumer demand (e.g. people will buy more when their incomes are higher or they feel richer because of their stock/property investments). Ugly inflation (e.g. 7%->10%) occurs when prices rise due to a complex combination of higher costs, higher demand, wage pressures and worst of all, spiralling expectations that the domestic currency's purchasing power is declining by the day."

(seeing the common topics, I hope to link your url on my bloglist if you do the same.)