Introduction
Economics is the basis for the development of human society. Today, all spheres of human activity are based on economic factors and work to achieve economic and financial goals. Accordingly, any difficulties faced by the economy of every particular country become instantly reflected in the social life, industrial development, and such essential issues as monetary relations. Regulation of the latter is seemingly one of the most important aspects of the activity of any central bank in any country. Although according to Friedman (1968, p. 2), there was a period after World War II when monetary policies were underestimated, the course of historic development proved the vital significance of monetary policies taken by central banks as attempts to regulate the country economic development and rates of inflation and deflation.
Background Information
Roles of central banks: Thus, the role of central banks in carrying out monetary policies to regulate the economic life in a country has not always been acknowledged by scholars and economists. As Friedman (1968, p. 2) argues, there were times after World War II, when monetary policies were considered unnecessary, and central banks were viewed as mere issuers of money and regulators of exchange rates. Such views resulted in great rates of inflation in many of the world’s highest developed countries, as relying on the self-stabilizing qualities of economic markets and interest rates proved to be inadequate (Friedman, 1968, pp. 2 – 3). Accordingly, new approaches to central banking were taken p by specialists and discussed by scholars.
Monetary policies: Bernanke and Mishkin (1997) already argue about central banks as determinants of the national monetary policies and developments in economic life (p. 97). These scholars attribute special importance to the role of central banking in fighting the inflation rates in a country arguing that central banks should deal with “inflation targeting” for the common good (Bernanke and Mishkin, 1997, p. 98). Further on, central banking is also considered as the means of price regulation. However, McAleese (2004) argues that, apart from purely economic factors, the center should be provided with a considerable extent of political autonomy, i. e. be independent of any political force in the country or abroad (p. 292).
Independence of Central Banks
Needless to say, one of the most important, if not exclusively the most, aspects of a central bank’s functioning is its independence. Although scholars like Sloman (2006) and Bernanke and Mishkin (1997, p. 87) argue that in real-life conditions central banks can hardly be independent, there should be measures taken to increase central banks’ independence or provide it to them to the fullest extent. Accordingly, though essential results have not been achieved yet, trends towards greater independence of central banks started being observed already in the middle of the 1990s (Bernanke and Mishkin, 1997, pp. 87 – 88).
Further on, scholars like Svensson (2003) and Sloman (2006) argue that the independence of central banks is essential for the success of any particular monetary policy and the overall conditions of the country’s economy. For example, if a central bank in a country is independent, its inflation targets are perceived as reliable ones, which creates a positive economic environment and prevents panic in the market (Svenssonm, 2003, 155). At the same time, if besides a central bank there is an authority in a country that shares control over monetary and exchange rate policies with the central bank, there might be confusion of responsibilities and unstable situation in the country’s economy, which might be taken as the loss of the central bank’s credibility and independence (Svenssonm, 2003, 157).
Stressing the importance of central bank independence, Bernanke and Mishkin (1997) distinguish the concepts of goal independence and instrument independence (pp. 101 – 102). According to scholars, the goal of independence is the freedom to set goals, which is not very essential. Even if the economic goals are set by the government, or by the central bank under advice by the government, this cannot influence the achievement, or failure to achieve, of those goals. At the same time, the instrument independence is a more essential notion as it presupposes that the central bank is free to choose ways to achieve the country’s economic goals, and is independent of any political or social forces in its activities (Bernanke and Mishkin, 1997, pp. 101 – 102). So, the instrument independence of central banks is especially important, and the closer a central bank gets to such independence, the more successful its monetary policies can be.
Monetary Policies Adopted
General notions: Naturally, scholarly ideas about the functions and monetary policies of central banks have not been derived from anything. There is a great variety of specific examples of monetary policies that central banks of different countries implemented with fluctuating degrees of success. Anyway, they are all worth considering, while they present a rich field for research. The basic central banks’ monetary policies include:
- Inflation targeting;
- Lowering the interest rate;
- “Quantitative easing”, or expansion of the country’s monetary base;
- Exchange rate targeting;
- Currency pegging.
Inflation targeting: One of the most commonly used monetary policies by the central banks of different countries is the so-called “inflation targeting” (Griffiths and Wall, 2004, p. 393). Bernanke and Mishkin (1997), discussing this monetary policy, stress its openness and the opportunity to the public control of the central bank performance. The point here is that inflation targeting is “is characterized…by the announcement of official target ranges for the inflation rate …and by an explicit acknowledgment that low and stable inflation is the overriding goal of monetary policy” (Bernanke and Mishkin, 1997, p. 97).
Simply put, when central banks take up the monetary policy of inflation targeting they publically announce which levels of inflation they consider being the most acceptable for the country at the time of the announcement, and the community traces how successful central banks are in their attempts to reach the announced inflation levels. The examples of successful inflation targeting usage by central banks are numerous and include the central banks of England and New Zealand, Canada and Israel, Sweden, and Mexico (Walsh, 2002, p. 333). The European Central Bank also resorted to inflation targeting between 1999 and 2002.
Lowering the interest rates: Another notable monetary policy implemented by a large number of central banks is lowering the interest rates (Svensson, 2003, pp. 147 – 148). This monetary policy is based on the assumption that inflation can be too low, and the phenomenon of deflation can do much harm to the country’s economy. The point here is that when inflation targeting is used by a central bank, the so-called “supply and demand shocks” can bring unexpected changes to this policy. Inflation can drop below the targeted level, which might lead to deflation and the liquidity trap, i. e. the situation when there are excessive amounts of currency and people prefer to hold them rather than invest or lend at current interest rates.
In such a situation, lowering interest rates might allow a central bank to make money holders invest in them expecting a further decrease of interest rates. Svensson (2003) argues that such a monetary policy can be beneficial, if everything goes as planned, but can also be rather dangerous in case if deflation emerges. If this happens, a central bank has to lower the interest rates below zero, which is irrational as no investor would lend money at negative rates. Such a case, according to Svensson (2003, p. 146) and Obstfeld and Rogoff (2002, p. 506), is called a liquidity trap accompanied by deflation and can be one of the negative effects of lowering interest rates by central banks. An example of implementing such a monetary policy is the central bank of Japan that carried out lowering of interest rates between 1999 and 2003 (Svensson, 2003, p. 148).
Quantitative easing: Quantitative easing, according to Svensson (2003, p. 152) and Begg, Dornbusch, and Fisher (2008, p. 191), is also a controversial central bank monetary policy used by the central banks of Japan, Russia, etc. On the one hand, such a policy can reduce real interest rates and increase inflation in light of the emerging liquidity trap and deflation. The point here is that the central bank artificially increases the monetary base in the country so that additional funds emerge for investment and lending even at the interest rates close to zero ones. At the same time, holders of money also start investing as they see that the expanded money base might make them lose profit if they wait for interest rates to grow. As Svensson (2003) notices, monetary base expansion causes inflation growth, but it protects the country’s economy from deflation.
Exchange rate targeting and currency pegging: Finally, the two integrally connected monetary policies by central banks can also be used to handle inflation and deflation. These are exchange rate targeting and currency pegging. According to McAleese (2004), currency pegging, also known as currency anchoring, is a valuable tool in maintaining the confidence of people in their currency and in establishing the international credibility of the currency (p. 299). By showing the value of a currency over other major world’s currencies, a central bank proves its commitment towards price stability and inflation reduction. The exchange rate targeting is thus an element of currency pegging.
Using this monetary policy, the central banks announce the desired exchange rates of their domestic currencies and work on achieving, or maintaining, this level. Such monetary policies are used mainly in developing countries that peg their currencies to the ones of the highly developed states (McAleese, 2004, p. 300). For example, before Euro was introduced in EU countries, the central banks of Austria, Belgium, and the Netherlands pegged their currencies to the Deutschmark.
Effects of Central Bank Policies
Assessment of Policies’ Effectiveness
General notions: Thus, after the major monetary policies implemented by the central banks of the USA, England, Japan, and EU member countries are discussed, it is necessary to consider the extent of effectiveness they had. Although all the monetary policies discussed, including Inflation targeting, lowering the interest rate, “quantitative easing”, or expansion of the country’s monetary base, exchange rate targeting, and currency pegging, are designed for reaching positive results, their real effects were controversial.
Inflation targeting effectiveness:Thus, the monetary policy of inflation targeting was, and still is, used by central banks around the world, and proved to be successful in the majority of cases. As a result of using the inflation targeting policy, the Deutsche Bundesbank managed to stop the development of inflation, and its actual rate by the end of 1979 proved to be 2% instead of the forecasted 4% level. A similar success was achieved by the central banks of England, New Zealand, Canada, and Sweden that resorted to inflation targeting in the late 1990s. The central banks of these countries managed to reduce inflation and steady decrease from 8.2% in 1979 to 1.8% in 2003 (Svensson, 2003, p. 146).
Effectiveness of lowering interest rates: The question of the effectiveness of the monetary policy according to which central banks lower interest rates for loans and credits is much more controversial and far less successful than the same issue regarding inflation targeting. For instance, between 1999 and 2003, the Bank of Japan introduced the extensive policy of lowering real interest rates trying to reduce the permanently growing deflation rates in the country (Svensson, 2003, p. 146). Such a policy resulted in Japan’s state debt amounting to 150% of its GDP by 2001, and the situation in the country is still worsening (Begg, Dornbusch, and Fisher, 2008, p. 183). Another example of the failure that central banks implementing lowering of interest rates faced includes the U.S. Federal Reserve that used such a monetary policy during the Great Depression and, as Svensson (2003) argues, conditioned the fall of the American GDP by 30% and prolongation of the Depression for one or two years (p. 148).
Quantitative easing effectiveness: Further on, another monetary policy of doubted quality often employed by central banks is the so-called quantitative easing, i. e. expansion of the monetary base in the country. As the examples show, this policy was used by several countries, including Japan and Russia, but it seems to have never proved effective in regulating inflation and deflation figures for any country. Moreover, Griffiths and Wall (2004) and Batini and Yates (2003) argue that expansion of the monetary base can facilitate inflation or deflation, and the country will then need years to decades to fight the consequences of such a monetary policy.
Japan is one of the brightest examples of this point as after the Bank of Japan, fighting deflation between 1999 and 2003, increased the mass of money grew by 50%, deflation dropped only 1 to 2 percent during those years, while the state debt grew and the country’s GDP decreased substantially (Svensson, 2003, p. 148). Russia is another example of the failure that monetary base extension caused. In 1998, the country’s central bank carried out a massive campaign of issuing additional money but the result, according to Obstfeld and Rogoff (2002, p. 516), was the complete economic collapse after which the Russian central bank had to reform the whole monetary system and is still in the process of recovery.
Results of exchange rate targeting and currency pegging: Finally, the monetary policy of exchange rate targeting as a part of currency pegging proved and still proves, to be effective for the majority of central banks that resort to them. According to McAleese (2004), this is probably explained by the fact that such a monetary policy is implemented by developing countries, the currencies of which need support and proof of credibility (p. 299). Simply put, the central bank of the country, where the currency’s rate is fluctuating and unstable, pegs its currency to one of several world’s leading currencies and thus increases the international confidence about this currency.
Austria, Belgium, and the Netherlands succeeded in their pegging to the Deutschmark before Euro was introduced in 1999, and managed to achieve inflation rate declines of about 2% annually (McAleese, 2004, p. 300). Countries like Denmark and Bulgaria pegged their currencies to Euro, and are now enjoying the benefits of Euro strengthening, observed even despite growing inflation rates in the EU member-countries (Batini and Yates, 2002, p. 291; McAleese, 2004, p. 300).
Implications for Inflation and Deflation Control
Thus, the comprehensive analysis of the monetary policies implemented in different periods by central banks of such countries as the United States, England, Japan, Russia, Germany, and many others allow seeing that there are effective and non-effective monetary policies. Their effectiveness in the work of central banks is measured by their ability to handle inflation and deflation in given countries. The above-presented data, thus, show that inflation targeting and currency exchange targeting combined with currency pegging prove to be efficient. The examples of central banks of Germany, Canada, New Zealand, and England show that inflation targeting policies allowed those countries to achieve the desired low rate of inflation.
At the same time, monetary policies like lowering interest rates and expanding the monetary base of the country prove to be ineffective based on the presented examples. Japan introduced lowering interest rates and faced the increase of the state debt to the extent that outweighed the country’s GDP. Russia resorted to monetary base expansion and experienced an economic collapse. Accordingly, the examples of monetary policies implemented by the central banks of the mentioned countries illustrate how important it is to select the fitting policy and implement it timely and properly.
Conclusions
So, the above-presented discussion allows concluding that monetary policies are major functions of the central banks in different countries. No economic initiative can be successful in all cases without exception. The approaches exercised by the U.S., British, Japanese, and other central banks prove that this point applies to the monetary policies as well. Some of the considered policies proved to be very effective, while others did not change a thing in the economic life of certain countries. In any case, the process of central banking by the way of executing monetary policies is far more effective than the passive approach that allows the economic development of the country to drift and stabilize, or come to stagnation, on its own. Central banks should fulfill their functions and impact the countries’ economic lives.
Reference
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