Central bank: functions
Regardless of its position and organizational form, a modern central bank has to carry out several specific tasks in order to achieve an optimum level of economic stability. The reasons for the existence of a central bank are: (i) protection of the internal value of the national currency; (ii) protection of the external value of the national currency; (iii) maintenance of ‘health’ of the national financial system; (iv) ensuring balanced economic growth and development and (v) the development of financial (money and foreign exchange) markets.
Generally speaking, regulations do not impose a hierarchy of requirements and tasks on the central bank. Even in countries with a similar economic structure and level of development, the central bank has quite different priorities. For instance, in Guyana and Jamaica, economic development is given a priority, while the Bahamas accepts a more classical concept, preferring price stability (monetary stability). So, in practice, the legal framework can define either one target or a set of them for the central bank. (Sevic and Sevic, 1998). In the past a range of targets was preferred, but it seems now that one (principal) target is more common. It is argued that a precisely defined target can eliminate all possible perplexities and facilitate the central bank’s efforts in its achievement. This is especially true for transitional and developing economies with a poorly developed financial structure (Sevic, 1996b). However, countries require the central bank to perform well and to influence the financial flows in the domestic economy, and to stress growth and development, the sustainable growth of real output, high employment and price stability. Even the Americans have not opted for a unique definition of the task, defining the objectives of their economic policy thus: ‘... the objectives of U.S. monetary policy are high employment, stable prices (no inflation) and growth in output on a sustainable basis. The ultimate goals, as they are often described, are not directly under control of the Federal Reserve’ (FRB of San Francisco, 1987). However, it has been observed that ‘when monetary policy aims at several objectives simultaneously, with the need for choice and balance between them, policy will be subject to greater political oversight and the CB [central bank] will be subservient’ (Goodhart, 1994, p. 1427). Consequently, greater autonomy can be achieved when the central bank must meet one single objective. Also, in the situation where there is a set of objectives, the principal-agent problem appears. The senior management is in a position to define priorities, and in some cases may overlook the primary (ultimate) goal. Moral hazard and adverse selection situations are likely to appear.However, even if the central bank has only one objective, this is usually very broadly defined. ‘Price stability’ may be the ultimate goal, but how can it be achieved? The legal position of the bank makes necessary presumptions, but does not guarantee the effectiveness of the central bank’s actions. Central bankers must find an immediate target to allow them to achieve an acceptable final outcome. This is why central banks, especially in small, open economies aim at something more feasible to control, such as the exchange rate. Central banks in market-based economies applying monetary policy affect the yields on financial markets. Consequently, the exchange rate is an important asset price that can be targeted (Goodhart, 1995).
New Zealand’s experience with the central bank contract has opened up another debate. The problem there is how the central bank can fight inflation (maintain price stability; that is no inflation at all), if it has been given an a priori inflation target, usually up to 4 per cent. The concept of price stability conflicts with previously agreed and usually politically sponsored inflation levels. This approach has shown itself quite efficient in the New Zealand case, although there are doubts over its long-run effects (Tietmeyer, 1994).
With a contractual obligation to keep inflation below an agreed level, the central bank is forced, in practice, to abandon the immediate target strategy, and to adopt ‘one-stage strategies with direct price target’ (ibid.). Anyway, practice has shown that central bank officials, as a rule, prefer to have a final price objective, rather than to define and follow an immediate target. This can be an argument in favour of a central bank contract. The practice of New Zealand, Canada and the United Kingdom has shown that the final objective can be achieved even when immediate targeting is abandoned. In New Zealand, even wage bargaining between trade unions and the government is always in ‘the shadow’ of the central bank contract. Trade unions’ desire to have a pay rise of 8 per cent and more is, as a rule, defeated by the NZ Reserve Bank, which limits the rise of all inputs of production up to the desired rate of inflation, in order to fulfil the contract.The conduct of monetary policy is currently the most important duty of the central bank and it takes a great amount of a central bank’s time and efforts. However, the functions of the central banks are much broader than to meet the (primary) objective of monetary policy. Theoretically they are defined as (i) issuing and cancelling banknotes and coins; (ii) foreign exchange reserve management; (iii) banker of the state (government’s banker); (iv) bankers’ bank, when acting as an LLR, (v) supervision of banks and other financial institutions, and (vi) facilitating the payment system (Sevic, 1996b). Also the central bank can be involved in foreign exchange control. Even in the defining of the other functions, there are large differences among countries. For instance, in Germany, Canada, Belgium and some Latin American countries, supervision of banks is carried out by structures not belonging to the central bank. In the United States, the responsibility for bank supervision is shared by the Federal Reserve System (the Fed), the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), and the state bank supervision authorities (Spong, 1990).
Functions within foreign exchange operations and control are very often shared with the state administration authority in charge of fiscal affairs (usually Ministry of Finance). A close connection between the central bank, even when it is independent, and the government is required when it is necessary to coordinate monetary and fiscal policies. In this situation the legal and institutional framework cannot help greatly, since it is always a question of mutual prestige.The formal obligation of the central bank to deliver the target level of inflation can be a way to assess the achievements of the central banks management. The central bank’s governor (president) may be reappointed if he or she succeeds in achieving the target(s) stipulated in the contract. However, there is also the case when the central bank exhibits the ‘public’ part of its nature: the central bank officials do not want to have their rewards linked to their results (Goodhart, 1994). They rather opt to have flat, stable civil servants’ salaries. However, if the bank is to make price stability a primary and ultimate objective, control must be tighter, and an incentive system properly developed. This is another question where the law and economics literature can provide answers. Central bank independence is always legally defined, but its application in practice attracts special attention, because it affects overall central bank performance.