Sunday, October 6, 2013

Two camps of what a central bank is


Broadly speaking, for at least 115 years (and possibly longer) – that is, at least since the publication of the Swedish economist Knut Wicksell’s Geldzins und Güterpreis (Interest and Prices) in 1898 – economists have split into two camps with respect to what a central bank is and the purposes it should serve.
One camp, call it the Banking Camp, regards a central bank as a bank for bankers. Its clients are the banks; it is a place where banks can go to borrow money when they really need to; and its functions are to support the banking sector so that banks can make their proper profits as they go about their proper business. Above all, the central bank must ensure that the money supply is large enough that mere illiquidity, rather than insolvency, does not force banks into bankruptcy and liquidation.
The other camp, call it the Macroeconomic Camp, views central banks as stewards of the economy as a whole. A central bank’s job is to uphold in practice Say’s Law – the principle that output is balanced by demand, with neither too little demand to purchase what is produced (which would cause unemployment) nor too much (which would cause inflation) – because Say’s Law certainly does not hold in theory. In other words, a central bank’s primary responsibility is not to preserve the health of the firms that make up the banking sector, but rather to maintain the robust functioning of the economy as a whole.

Read more at http://www.project-syndicate.org/commentary/the-rationale-and-purposes-of-central-banks-by-j--bradford-delong#4s11mVLJjCXhv02D.99

Brad DeLong has done a nice job of describing the two view concerning the purpose of central banks. One simple problem is that at any time the central banker does not agree on what it should be. There are actions when they act like a banker's bank and other time they behave like the Macroeconomic Camp. There is not really a dual mandate, but a fight between these two roles. Under normal times, the Banking Camp represents the central bank. During recessions, the other camp takes over.

All Fed actions can be placed in either camp. The confusion comes when the market expects the Fed to act like a banker's bank and it does not.

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