12) The role of the central bank

Question 1

What are the 4 main functions of the central bank?

Answer 1

• provide banking services to banks and the government
• control of the money supply
• lender of last resort
• set interest rates

Question 2

How does the role of an independent central bank differ from those of a central bank under government control?

Answer 2

-independent bank is not bound or affected by political decisions whereas government controlled banks have often been influenced by political pressure which encouraged boom and bust cycles

Question 3

Why is an independent central bank better or worse than a government controlled one?

Answer 3

better-
-may have more credibility which increased confidence and helps reduce inflationary pressure

worse
-sometimes stick too rigidly to unsuitable economic targets. eg low inflation when they have bigger problems like low economic growth and high unemployment to deal with

Question 4

What are the two main policy measures available to the central bank and how are they used

Answer 4

• setting the base rate; rate will be encouraged to increase saving and slow economy down and vice versa
• Quantitative easing- digitally creating cash to buy government bonds from the banks, giving them more cash to lend out and increasing investment/AD

Question 5

What are the primary and secondary objectives of the bank of England?

Answer 5

Primary- to achieve and maintain a stable price level ie 2% inflation
secondary- to help the government achieve its other macroeconomic objectives

Question 6

What are the benefits of inflation targeting?

Answer 6

• Helps to keep prices stable if done effectively, therefore the adverse affects of inflation ie unemployment and inequality are less felt by an economy
• often stable prices are a major contribution to good economic growth

Question 7

What are the drawbacks of inflation targeting??

Answer 7

-Central banks start to ignore other problems like unemployment eg the ECB keeping inflation down in the eurozone but not managing the double dip recession

Question 8

What evaluative points are there to argue about the BOE use of inflation targets?

Answer 8

• state of the economy; naturally low inflation would suggest the bank is wasting its tine stressing over it, and could be spent targeting other things
• type of inflation; interest rates are more effective at targeting demand pull instead of cost push inflation
• the target- sometimes slightly higher inflation can be a good thing

Question 9

What are the advantages and disadvantages of changing the interest rate in achieving objectives and what does it depend on?

Answer 9

ADV- should directly affect AD by making it easier or harder to borrow money

DIS ADV- can be regressive, higher interest rates benefit savers who are usually higher income and have higher MPS compared to lower income people

depends on- rate to start with, if the rate is very low a small decrease will have little effect

Question 10

What are the advantages and disadvantages of QE in achieving objectives and what does it depend on?

Answer 10

ADV- can be effective by increasing the money available to banks and therefore encourage loans and investment

DIS ADV- it can be inflationary because the created money could lead to an increase in the money supply (demand pull) also increases asset prices eg shares and bonds benefiting the well off and increasing equality

Depends on- whether the banks hold onto the extra cash and decide not to lend, may be banks with liquidity problems that decide not lend

Question 11

What does the lender of last resort mean?

Answer 11

• the central bank offering liquidity support to financial institutions which are struggling to secure sufficient cash flow
• however they DO NOT usually offer financial support to banks that have failed due to irresponsible and reckless invested

Question 12

What are the advantages of using lender of last resort

Answer 12

-through its discount and credit operations, they provide short term liquidity help from problems rising from seasonal fluctuations- this may help to prevent the collapse of a bank

Question 13

What are the disadvantages of using lender of last resort?

Answer 13

• shifts the risk and responsibility away from lenders and borrowers and towards the bank, as banks take higher risks because they know the banks will bail them out
• -MORAL HAZARD;
• may encourage inflation as LOLR will buy government bonds from the bank concerned, increasing Money stock

Question 14

Evaluation points for LOLR role?

Answer 14

• Hard to decide whether a bank is illiquid and suffering from cash flow problems due to seasonal fluctuations, or at risk of being insolvent because they weren’t careful with their investment and have illiquid assets
• size of the institution, bigger firms are much more likely to be bailed out than smaller institutes because they are more integral to the whole financial systems