Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Role of a Regional Bank in a System of Central Banks

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Role of a Regional Bank in a System of Central Banks

Article excerpt

A modern central bank seeks to maintain a financial environment within which competitive markets support the efficient use of productive resources. The overarching principle is that a central bank should provide the necessary monetary and financial stability in a way that leaves the maximum freedom of action to private markets. In keeping with this principle, monetary policy is implemented by indirect means, with an interest rate policy instrument rather than with direct credit controls. In the banking sphere every effort is made to minimize as far as possible the regulatory burden associated with financial oversight.

The principle that markets should be given free reign wherever possible creates three difficulties of understanding that a central bank must overcome in order to carry out its policies effectively. The presumption that monetary and banking policies are best when they are as unobtrusive as possible creates the first difficulty. Inevitably, central banks seem shadowy and distant from the public's point of view. Yet, to work well, central bank policies need to shape the expectations of households and businesses. Monetary policy encourages economic growth and stabilizes employment over the business cycle by anchoring inflation and inflation expectations. Bank supervision and regulation aims to promote confidence in the banking system.

The need to influence expectations and promote confidence puts a premium on credibility, a commitment to goals, and a central bank's perceived independence and competence to achieve its objectives. Thus, a central bank must create in the public's mind an understanding of the methods by which its objectives can be sustained. This formidable problem has to be overcome in spite of the fact that a central bank operates in the background, with obscure methods and procedures.

The second and third difficulties arise because central bankers must understand markets. Dynamic markets introduce evermore efficient productive technologies and create new goods and services to better satisfy consumer wants. Economic dynamism complicates the measurement of macroeconomic conditions. A central bank seeks to understand the latest market developments in order to implement monetary and banking policies appropriately. Policy actions are inevitably benchmarked against historical correlations in data. Yet a central bank must be prepared to question its interpretation of data in light of anecdotal and other information that suggests behavior different from historical averages.

The third difficulty of understanding is in the area of economic analysis. Because policies influence economic activity indirectly, central bankers must use economic analysis to think about how their policies are transmitted to the economy. Some sort of quantitative theoretical model must be used to think about how markets respond to monetary and banking policies, and how monetary and banking policies ought to react to the economy.

The role of regional banks in a system of central banks is about creating understanding in the three senses described above. For example, decentralization enhances credibility because the diffusion of power makes it more difficult for outside pressures to be brought to bear on a central bank. The regional presence helps a central bank to get its policy message out and to gather anecdotal and specialized information on regional economies. Information gathering and dissemination are particularly important for central banks such as the Eurosystem and the Federal Reserve System, whose currency areas span large and populous regions. For this reason, the Central Bank of the Russian Federation and the Peoples Bank of China might profitably restructure themselves as a system of regional central banks.1

A regional presence also benefits a central bank with responsibilities for bank supervision and regulation, and the power to extend emergency credit assistance to troubled financial institutions. …

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