An Investigation of the Role of Central Banks in Economic Stabilization

The traditional role of the central banks before the financial crisis can be generalized in three main functional and objectives roles. The first one is to keep price stabilization, concern to the financial regime in contemporary operation, as an example the gold standard, a pegged rate of conversion or an inflation rate target. The second one is to maintain financial stability, and to faster financial development more extensively. And the last one is to assist the country’s financing desires at times if crisis, however in normal times to constrain misuse of the nation’s financial powers. Within the past this meant stopping debasement and misuse of the inflation tax. The first (Victorian) and third (1979-2007) epochs of Central Banking were characterized via noticeably successful financial regimes (Gold standard and inflation Target), reliance on marketplace mechanisms and independent Central Banks. After an inter-regnum, post WWI, the first epoch came to a crashing halt in the 1929-1933 industrial Depression and deflation then caused a period of government domination, direct controls and subservient Central Banks. In the aftermath of the financial crisis of 2007-2010, there has more intrusive regulation, greater government involvement and less reliance on market mechanisms compared with before. The paper will explore how the changes in market conditions have increased the need for the regulation of monetary and financial markets by central bank to enhance economic growth and market stability. Through encouraging government control of the economy using the central bank eliminates the various market risks and enhances economic growth and stability.

The Keynesian theory is among the first provisions underlining the need for government control in the financial market. Keynesian theory encourages government intervention by encouraging spending during a boom and injecting liquidity during recessions. Keynes argued that classical theorist only considered two forms of unemployment: frictional and voluntary unemployment. The Keynesian theory expresses the importance of government control of the market to control unemployment and inflation. Whilst 30 million people are inclined and capable of work but three million of them are unemployed, Keynes argued, individual markets may be doing a perfectly accurate task of allocating the efforts of 27 million workers—the problem is that insufficient aggregate demand exists to support jobs for all 30 million. As a result, he believed that—at the same time as authorities need to make sure that overall level of aggregate demand is enough for an financial system to reach full employment. The use of Keynesian theory allows the government to control unemployment and inflation rate, thus ensuring market stability.

Contrary to Keynes provisions, Hayek discourages government interference and instead advocates for a self-regulating market system. Hayek argues that government control denies market independence and can be harmful to businesses. Hayek formulated a concept of freedom of markets to demonstrate the importance of liberal capitalist societies over other forms of societies. This approach is based on the premise that the best market is self-regulating. Any marketplace where purchaser and supplier might also refuse to trade and the terms and effects are totally determined by using all contributors voluntarily will have a tendency in the direction of equilibrium price where the demand curve and supply curve would intersect. This includes monopolies, due to potential competition amongst different motives. Both consumer and supplier have needs that oppose and compliment each other and if the transaction is voluntary each believes that the transaction was an improvement. Despite the fact that a worker may also want countless cash for no work and company may want endless work for no pay of labor, the voluntary nature keeps the real price in balance. Political marketplace and any coercion bring about disequilibrium. Inevitably, one party advantages at the cost of some other of the transaction is regulated, mandated or otherwise interviewed with. Basically, this is due to the fact value is subjective and dynamic. Only a voluntary transaction can reveal the relative preferences of products and consequently the fair market value. To sum up, Hayek advocates for a self-regulating system that respects and promotes the independence of markets.

There are some strategies employed by the central bank to control the economy and money markets. The control of the economy by control of the market by injecting liquidity to control unemployment. According to Hetzel, the government controls the market by controlling liquidity either by tightening or easing borrowing. The control of liquidity leads to an adjustment in the interest rate rates, thus easing or tightening the borrowing market. This can either lead to inflation or ease unemployment by encouraging investment. Money is created whenever banks supply new loans to clients, caused by way of new cash deposits of their bank. New financial institution deposits can create a multiple credit expansion throughout the banking system, increasing liquidly and permitting fresh loans to be made as a multiple of the original deposit. In effect, money increases while fresh loans are advanced to clients. The formula to calculate how much extra credit can be given is known as the credit multiplier and is 1/cash Ratio. as an instance, if the cash ratio is 0.1, the credit multiplier is 1/0.1 = 10, and a fresh cash deposit of £1,000 should lead to fresh advances to clients of £10,000. this is due to the fact the new deposit of £1000 need only constitute 10% of total monetary assets. this means that every new £1 received via the bank might be used to generate £10 of credit within the form of advances to other clients. Secondly, issuing Treasury bills can also add to the cash supply, and this occurs while the authorities borrows from the money market by issuing Treasury bills. Banks deal with these bills as being 'as good as cash', and keep to make the same amount of loans to their customers. this is despite the truth they have lost liquidity by means of buying bills from the Treasury. The net effect is that cash supply inside the economy increases. Thirdly, the central bank, the financial institution of Britain, can print new cash if the normal flow of liquidity is disrupted, as in the latest financial meltdown. The financial institution can use this new money to buy up existing government debt, including bonds held with private firms, so injecting new liquidity into the system. This process is referred to as quantitative easing. Changes in the money supply, or a component of the money supply, do not always have a predictable effect on the inflation rate. One explanation for this is contained in Goodhart’s law. This states that, as soon as a selected instrument is used for policy purposes, the relationship between the tool, such as MO, and the objective, stable prices, starts to weaken. As soon as a financial authority tries to modify the money supply to lessen inflationary strain, the stable relationship that might have existed among money (M) and prices (P) will break down, and trying to manipulate M is probably to fail. therefore, instead of control the cash supply, which is perhaps uncontrollable, financial authorities manage economic situations through setting short time period interest rates, which work through their effect on the demand for money, rather than supply. To sum up, the government controls the money market by eliminating or injecting liquidity to adjust the interest rate and inflation levels.

How fiscal policies can adversely affect the economy, the use of fiscal policies according the government can control the market. The government can use fiscal policies to encourage unfair competition especially among multinationals that tend to have monopoly powers. Also, this can be used to encourage corruption through inside trading. There has been considerable agitation from the business community, and particularly from small businesses, against unfair competition from nonprofit firms. The source of the unfairness, as the business community see it, is that nonprofit corporations often receive special legal privileges that are denied to competing for profit firms. Most conspicuous among these privileges is tax exemption, particularly exemption from federal corporate income taxes. State-owned enterprises are not competitive, and various monopolies have jeopardized fair competition, hindered the development of the market economy, suppressed innovation, and led to many corruptions. In conclusion, fiscal policies can be used to create an unfair market as well as encourage corruption.

The importance of central banks is regulating the market and maintaining stability. Allows the government to manage money market risks. Helps monitor changes in market conditions and ensure the positive performance of the market. According to IMF, the central banks helps regulate market risks as well as introduce stringent policies to eradicate fraud and ensure market stability. Also, this ensures that the market is responsive to changing market conditions by monitoring the performance of the economy within a given period. The central banks must make an active contribution to improved market transparency, first and most important through helping market initiatives in this regard and thereby helping to support the identification and analysis of systemic risks. As an example, securitisation might be made greater transparent, leading to the availability of better, more accurate statistics at the cost of underlying property – particularly loans. enhancing the infrastructure utilized by issuers and investors to exchange statistics on complicated financial products could increase transparency and foster marketplace innovation, while decreasing systemic risk. Without such initiatives, critical market segments could fail to recover from the intense decline in activity due to the current crisis. Such markets are critical in allowing financial institutions to secure asset‑based investment, expand lending and better distribute risk. They contribute to the performance of the financial system, and so a failure to revive them might entail giant social costs. The central bank can help manage risks within the market and constantly monitor market performance over time.

The increase use of fiscal policies can adversely impact the market. Increased government control in the financial and monetary systems denies the market its independence. According to Botman and Kumar, increased use of fiscal policies denies the market its independence. As such, this violates the need for a free market without government control. To sum up, the increased use of fiscal policies denies markets the ability to arrive at an equilibrium without external intervention.

How fiscal policies can be used in market risk management. The use of fiscal policies in commodity risk management. Goodhart argues that federal governments can make use of fiscal policies to regulate the amount and value of risk. This is done by controlling market liquidity at all times by adjusting the interest rates either to control commodity prices, inflation or unemployment in the market. To sum up, the federal government can regulate market risks using various fiscal policies to protect the interests of consumers.

The use of fiscal policies does not necessarily benefit the society. Fiscal policies can boost inequality in the economy. The use of fiscal policies does not necessarily promote market equality since some policies tend to benefit certain members of the society than others. This can promote all forms of inequalities, mostly income inequality. For instance, techniques used to control inflation tend to increase unemployment rates. The use of fiscal policies can encourage inequalities in the market since they tend to benefit certain members of the society.

This paper draws on the recent literature and international experience to assess the role of central banks in mitigating financial stability risks. The reaction to the global financial crisis, has demonstrated that promoting financial stability is a high priority for policy-makers, including central bankers. Institutional arrangements for micro- and macroprudential policy vary considerably across jurisdictions, with central banks playing different roles. In some countries central banks directly control micro- and macroprudential policies, while in others they have an advisory role. The use of monetary policy to mitigate financial stability risks appears to be an additional tool for central banks. However, the available evidence suggests that potential trade-offs with macroeconomic objectives can arise and the policy response needs to be carefully considered. In practice, central banks that tend to have stronger financial stability mandates and less influence over regulatory and macroprudential tools are more likely to use monetary policy to address financial stability risks. The financial system is by its nature ever-changing. An effective financial stability regime must, therefore, be dynamic. It must combine vigilance with flexibility to identify, assess and respond to new vulnerabilities as they emerge. The regime should progress as understanding deepens on the interactions between the financial system and real economy, as analytical and modelling capabilities advance and as the quality of data improves. By working in tandem with other agencies, central banks can make important contributions to the stability regime, based on their system-wide macrofinancial perspective and their analytical capacity. Because developing and implementing financial stability regimes remains a work in progress across jurisdictions, there are a number of priority areas for further research to better understand how to implement macroprudential policy and what role central banks should play in this process. First, it will be desirable to define as clearly as possible the standard of resilience in each jurisdiction. Second, to better understand the channels of financial and economic feedback, including contagion, the macroprudential policy framework should be extended by expanding the stress-testing framework beyond regulated banks to include other sectors of the financial system. Finally, more thinking is needed to develop effective co-operative approaches across public authorities to monitor, share information on and mitigate (or prevent) hidden actions, including financial innovation or mutation and regulatory arbitrage, especially cross-border. 

01 August 2022
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