Conflicts between Objectives and Dilemmas Faced by Central Banks - Literature review Example

Central Banks Have Several Objectives: Long-Run Price Stability, Business Cycle Stabilization, And Very Short-Run Exchange-Rate Targets. More Often Than Not, These Objectives Stand In Conflict With Each Other, Creating Dilemmas for the Monetary Authorities and Leading to Compromises among the Objectives...” – Critically Discuss This Assertion Table of Contents Introduction 3 Objectives of the Central Bank 4 Conflicts between Objectives & Dilemmas Faced By Central Banks 6 Conclusion 7 References 9 Introduction As theorists have often argued, the requirement of a non-profit bank for regulating and supervising the commercial banking system has led to the emergence of central banks globally. The primary responsibility of the central banks is to act as an agency for the implementation of monetary policies within the national boundaries that has today also expanded to control the trade relations at the global plethora. Besides, it also emphasises the functions of financial stabilisation and hence, becomes more active during the times of financial crisis. It also serves as a financial support to the country’s government. It is also owing to this reason that the minute detailed norms, structures and responsibilities might vary from one country to another for central banks. Notably, the central banks have various objectives, which principally comprise ‘long-run price stability’, ‘business cycle stabilization’, and ‘very short-run exchange-rate targets’. Thus, to achieve these objectives through the daily course of actions, central banks might face such situations when these objectives come in conflict to each other. In such cases, the central banks itself needs to find out measures to build a compromising state among these objectives for settlement, wherein the economy’s interests are given utmost priority (Nordhaus, 2005). Emphasising the stated issue, the main purpose of this report is to discuss about the three aforesaid objectives of the central banks and critically examine the reasons behind their conflicting natures, further addressing remedies that can be taken to mange them. Objectives of the Central Bank Arguably, there are three common objectives generally followed by central banks around the world, which are long-run price stability, business cycle stabilization, and very short-run exchange-rate targets. Price stability is an economic situation in which much change in commodity prices does not take place. This might take place for a very short span of time. As theorists argue, long run price stability is unrealistic in the real life scenario, as inflation or deflation rates keep changing the commodity prices within an economy and hence, making stability of prices a demanding function. However, it is referred as the central goal of a country’s monetary policy (Fontana & Vera, 2005; Taylor, 1996). Correspondingly, the other objective of central banks, i.e. business cycle stabilization, generally refers to managing the demand of a business with the help of monetary as well as fiscal policies for the sole purpose of reducing fluctuations in any case. This ultimately affects the needs of the individual people of the country, as it correlates with wealth distribution, capital flow and many more (Barlevy, 2004). The third most important objective of central banks can subsequently be denoted as very short-run exchange-rate targets, which depends on the fixing of the interest rate of the home country to such an extent that it gets balanced with the exchange rate of other currencies in time of exports and imports. This interest rate is likely to remain fixed for a very short span of time and might change as per the situation requires (Romer, 2012). The objectives of the central banks, as mentioned in the above discussion, are often argued to present a demanding situation to the managerial capacity within the banking sector, even when focused on individually – not collectively. A clearer understanding to the context can be obtained with reference to the elemental construct of these objectives based on their theoretical concerns. For instance, long run price stability denotes such a position wherein the changes in commodity prices are either too slow or negligible or completely absent, for the long term period. According to economists, gaining such a merit in the real life scenario is nearly impossible, since the world economics always faces fluctuations in the inflation or the deflation rates, with the intention of reaching a trade-off situation (Fontana & Vera, 2005; Taylor, 1996). Secondly, business cycle stabilization is also an entirely theoretical aspect, which is based on the various factors of business operations, imbibing their regular activities and their dependence on Foreign Direct Investments (FDI). This aspect cannot be realistically applied in any country as this might create an imbalance in income within the sectors and in turn might create an economic imbalance within the country (Barlevy, 2004). Again, as already mentioned above, very short-run exchange-rate targets refer to the intent of central banks for stabilizing the interest rates of the home country, in order to maintain a balance in the foreign currency exchange rates. Correspondingly, as this particular objective relates with the global economic system, and is strongly influenced by the foreign trade relations, national central banks are unlikely to control almost all the variables to assure such efficiency. It is owing to these limitations that the stated objective also presents quite a noteworthy challenge for central banks in the modern phenomenon (Romer, 2012). Other than these, a few more challenges that the central banks are facing today can be identified in the form of an augmenting pressures of financial stabilization on the global scale, the decline of the macro-levelled prudential policy, reappearance of the fiscal dominance and its threat. The banks’ reserves have also been putting forward a challenge of tightening the operational policy making the stated objectives of central banks arbitrary (Warburton & Davies, 2014). Conflicts between Objectives & Dilemmas Faced By Central Banks Arguably, conflicts between the conditions or basic tenets of long run price stability and business cycle stabilization, the two of the crucial objectives of central banks, have been quite distinctive and apparent. To be elaborated in this context, long run price stability refers to the trade-off situations in the country’s economy, which, in the long run, can be observed as inflexible in preventing the existence of business cycle stabilization completely, as it is only possible in the presence of continuous inflation or deflation situations. This clearly explains the disagreements between these objectives, owing to which, central banks do face a situation of dilemma, where it needs to select among them or introduce short or very short term policies to strike a balance in the country’s economy (Bernanke & Woodford, 2007). Long run price stability and very short-run exchange-rate targets, as argued by contemporary economists, are of great contrast to each other. For instance, when a central bank is completely focussed on the Short Term Monetary Policy dealings, it might bring in positive results in stabilizing the country’s economy at that point of time, but might create a severe conflict in the long run. Therefore, a country can never opt for both these objectives alongside, until and unless, an external power is available to manage the short term policies while the central banks take the responsibility to manage long term stabilisation policies entirely. In case of countries with Open economy, the nominal exchange rates can be used as an instrument to adjust the conflicts between these objectives, wherein minute losses in autonomous monetary policy and the loss of the sudden shocks in the global stock markets, are often observed to have an impact to the county’s economy (Tjirongo, 1995) From a critical point of view however, when considering the two objectives of central banks, i.e. business cycle stabilization and very short-run exchange-rate targets, it can be observed that the elements associated with the same are not actually conflicting in nature but creates a dilemma in the workings of the central banks. It is worth mentioning in this context that the exchange rates of a home country cannot always give a clear view to the business structure and its workings. The fluctuations of a country’s economy hence depend to a large extent, on the fluctuations in the capital flow of the country’s autonomous business organisations. The fluctuations in the capital flow of such autonomous concerns create a direct impact on the market trends, leaving its deep impression on the country’s economic conditions (Baker, 2008). Suggestively, the central banks must take some necessary measures to ensure the above mentioned objectives with a clear perception. Being at the core of the national financial system, central banks should be working based on a pre-organised framework and strategies ready for application to help the country survive in the long run and gain competitive advantages in the internal platform. It is with this intention that central banks need to follow certain predetermined guidelines for their better performances and control conflicts to provide solutions effectively (Ramsey & Head, 2000). Conclusion Based on the above discussion, it can be inferred that central banks function as an entity responsible for maintaining financial stability within a nation. In lieu, the central banks need to perform certain functions, such as implementation of the monetary and the fiscal policies, determination of interest rates, nation’s money supply control, regulating the other banking services, supervising the country’s entire banking sector, fixing the country’s interest rates, takes steps relating to the country’s FDI instances, which contributes to the greater objectives of these entities involving long-run price stability, business cycle stabilization, and very short-run exchange-rate targets. Summarising the findings obtained through the study, central banks also serve the country in its overall achievement of certain goals, such as high rate of employment and sustainable economic growth in both the short and the long runs. However, compliance to these objectives, especially when the attributes relates to the same are in conflict with each other in any given real life circumstance, the banks have to face certain challenges in its proper functioning. These issues mostly relate with currency exchange rates as well as national monetary policies implemented in the fiscal and monetary domains. It is also worth mentioning in this context that political influences play a major role in the overall functioning and effectiveness of central banks. References Baker, D., 2008. The Housing Bubble and the Financial Crisis. Real-World Economics Review, Issue No. 46. [Online] Available at: http://paecon.net/PAEReview/issue46/Baker46.pdf [Accessed June 19, 2015]. Barlevy, G. 2004. The Cost of Business Cycles and the Benefits of Stabilization: A Survey. NBER. [Online] Available at: http://www.nber.org/papers/w10926.pdf [Accessed June 19, 2015]. Bernanke B. S. & Woodford, M., 2007. The Inflation-Targeting Debate. University of Chicago Press. Fontana, G. & Vera, A. P., 2005. Are Long-Run Price Stability And Short-Run Output Stabilization All That Monetary Policy Can Aim For? Levy Institute [Online] Available at: http://www.levyinstitute.org/pubs/wp_430.pdf [Accessed June 19, 2015]. Nordhaus, S. 2005. Economics. Tata McGraw-Hill Education. Ramsey, R. L. & Head, J. W., 2000. Preventing Financial Chaos: An International Guide to Legal Rules and Operational Procedures for Handling Insolvent Banks. Kluwer Law International. Romer, D., 2012. Short-Run Fluctuations. University of California [Online] Available at: http://eml.berkeley.edu//~dromer/papers/Romer%20Short-Run%20Fluctuations%20January%202012.pdf [Accessed June 19, 2015]. Taylor, J. B., 1996. How Should Monetary Policy Respond to Shocks While Maintaining Long-Run Price Stability. Stanford. [Online] Available at: http://web.stanford.edu/~johntayl/Onlinepaperscombinedbyyear/1996/How_Should_Monetary_Policy_Respond_to_Shocks_While_Maintaining_Long-Run_Price_Stability_Conceptual_Issues.pdf [Accessed June 19, 2015]. Tjirongo, 1995. Short -Term Stabilisation versus Long Term Price Stability. Centre for the Study of African Economies. [Online] Available at: http://www.csae.ox.ac.uk/workingpapers/pdfs/9518text.pdf [Accessed June 19, 2015]. Warburton, P. & Davies J., 2014. Economic Perspectives. Central Banking. [Online] Available at: http://www.centralbanking.com/central-banking-journal/advertisement/2356392/the-reorientation-of-central-bank-policy-objectives [Accessed June 19, 2015]. Read More