Role of Central Banks Essay Example | Topics and Well Written Essays - 2750 words

Role of Central Banks - Essay Example Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy. Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can be damaging to the functioning of the economy. Low inflation can help to foster sustainable long-term economic growth 2. The central bank ensures that the money supply in the economy is exogenous and determines the monetary base accordingly for the actual values of the currency and reserve ratios etc. using the appropriate money supply formula. 3. The money supply is endogenous to the economy but is determined by the central bank according to a money supply rule, and the monetary base is changed to achieve the money supply determined according to this rule. The last assumption given above is the most commonly used operational technique, even where the central bank's intention is to focus on the monetary base or the money supply as the main determinant of aggregate demand. Under this procedure, the central bank sets the discount rate to achieve a certain level of aggregate demand in the economy and lets the financial sector determine the monetary base through borrowing or discounting bonds with it. ... rational technique, even where the central bank's intention is to focus on the monetary base or the money supply as the main determinant of aggregate demand. Under this procedure, the central bank sets the discount rate to achieve a certain level of aggregate demand in the economy and lets the financial sector determine the monetary base through borrowing or discounting bonds with it. In any case, the central bank's behaviour is captured through the specification of the monetary base, no matter which of the above procedures is used. The measures that are taken by a central bank typically involve altering the interest rate in order to control the rate of growth of aggregate demand, the money supply and ultimately price inflation. It also involves changing the exchange rates as fluctuations in the value of currency also have an impact on macroeconomic activity. All in all, these measures come under the banner of monetary policy of a country. The key result is that monetary policy governed by society's preferences produces an inefficient outcome featuring an undesired, high level of price instability. Society can improve on this suboptimal outcome in a number of ways. One way to achieve price stability without distorting the stabilization of shocks is to set new incentives for the central bank by picking a progressive central bank which cares a lot about income, making it independent of the government, and adding an inflation target to its environment.1 Monetary Policy Many economists believe that monetary policy is a more powerful tool than fiscal policy in controlling inflation. The circular flow of income and spending is kept in motion through changes in short term interest rates that in turn affect the spending and savings patterns of households and businesses