Central Banks as Economic Institutions

Central Banks as Economic Institutions

The Cournot Centre series

Edited by Jean-Philippe Touffut

The number of central banks in the world is approaching 180, a tenfold increase since the beginning of the twentieth century. What lies behind the spread of this economic institution? What underlying process has brought central banks to hold such a key role in economic life today? This book examines from a transatlantic perspective how the central bank has become the bank of banks. Thirteen distinguished economists and central bankers have been brought together to evaluate how central banks work, arrive at their policies, choose their instruments and gauge their success in managing economies, both in times of crisis and periods of growth.

Chapter 4: Financial Stability and Monetary Policy: A Framework

Gerhard Illing

Subjects: economics and finance, money and banking


Gerhard Illing1 INTRODUCTION Monetary policy has been a great success over the past 15 years: worldwide, inflation has been reduced steadily, and output volatility seems to be well under control. The performance of central banks in fighting inflation has been stunningly impressive. Whereas for a long time they were accused of suffering from dynamic inconsistency (the temptation to give in to incentives to carry out surprise inflation), the credibility of central banks now seems to be at its highest level ever. Following the advice of modern macroeconomic theory, which provides a sound welfare theoretical framework for price stability, most modern central banks try to stabilize the price level by steering aggregate demand via changes in nominal and real interest rates, respectively. The ‘New Neoclassical Synthesis’ (Woodford, 2003) provides a well-established framework for this approach to monetary policy, pointing out the crucial role of commitment in order to effectively influence long-term real interest rates by signalling the intended path of nominal rates in advance. According to prominent proponents of this framework, such as Woodford, money supply does not play a significant role. Just at a time when central banking practices seem to be converging with theory, there is increasing concern among practitioners that an excessively generous provision of liquidity contributes to excessive asset-price movements (increases in equity and housing prices), endangering financial stability. The fear that loose monetary policy contributes to a rise in asset prices with the risk of a serious breakdown of...

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