The Role of Central Banks in Money and Payments Systems

Abstract

I WOULD LIKE TO THANK BRUCE SMITH for the honor of participating on this panel with such distinguished experts on central banking and payments. Moreover, Bruce should be commended for putting together an outstanding conference on what is probably the most important issue that the Federal Reserve System (at least the Federal Reserve Banks) will need to grapple with early in the twentyfirst century. To understand the role a central bank should play in the economy one needs to think carefully about what forms of market failure require this form of government intervention in the market. The existence of financial intermediaries tells us that the perfect capital market assumptions that underpin the M&M irrelevance results do not hold. For policymakers, the question is not whether financial markets (money, capital, and payments markets) are frictionless. Rather, the question is, do the private-sector institutions that arise to mitigate (or arbitrage away) market frictions serve to complete the markets? If not, then public intervention in markets may be required. In this case, we are interested in the role a central bank may play in completing markets. The papers presented in this volume provide some answers as to the central bank' s role in money and payments. I doubt there is much controversy in asserting that central banks have a role in establishing the unit of account (although in small open economies a currency board may serve this function) and in serving as the liquidity backstop for financial markets. In turn, these two roles for the central bank may require that payments be ultimately settled in central bank liabilities (base money) and hence, be settled on the books of the central bank. What is not clear is the need for the central bank to provide the medium of exchange in the form of fiat money. A common theme across these papers is that properly structured private provision of money, or banknotes, is not only feasible, it may be desirable. The papers by Williamson (1999) and Cavalcanti and Wallace (1999) show that inside money (banknotes) results in superior outcomes with respect to economic ef-