What Should Central Banks Do? What Should Be Their Macroeconomic Objectives and Operations?

Abstract

Before turning to the normative question of what Central Banks (hereafter CBs) should do, we need to deal with the contentious issue of what CBs actually can do in the field of monetary control. One might think that this should be a relatively straightforward matter of fact. Instead, there is a yawning chasm of mutual misunderstanding, which has persisted for decades, between economists and those working in CBs, which has bedevilled the subject. Virtually every monetary economist believes that the CB can control the monetary base (hereafter Mo), and, subject to errors in predicting the monetary multiplier, the broader monetary aggregates as well. After all, Mo (apart from some relatively unimportant qualifications about coins from the Mint), represents the liabilities of the CB, and the CB should be able to control its own liabilities by open market operations. Hence the normal assumption is that Mo is controllable within a narrow margin. If the Central Bank should fail to do so, it must be because it has chosen some alternative operational guide for its open market operations, e.g. holding interest rates constant at some level, which operational rule is frequently decried as sub-optimal. Assuming that CBs can, almost perfectly, control Mo, economists have constructed several simulated schemes of how an optimal rule for so doing might be set up; McCallum (I993a, b) provides good recent examples. Almost all those who have worked in a CB believe that this view is totally mistaken; in particular it ignores the implications of several of the crucial institutional features of a modern commercial banking system, notably the need for unchallengeable convertibility, at par, between currency and deposits, and secondly that commercial bank reserves at the CB receive a zero, or belowmarket, rate of interest. The first means that fluctuations in the public's demand for cash, which are both strongly seasonal and somewhat unpredictable, must be accommodated. The second means that commercial banks will not willingly hold free reserves at the end of each day (assuming for this purpose that a stated reserve ratio has to be held on each day, rather than averaged over, say, a couple of weeks) beyond that needed to meet late fluctuations in the demand for cash after the money market has closed, or become thin. Only if interest rates fall to the very low levels of the I930s, and/or risks of interest rate variability or late-in-the-day cash runs increase, would commercial banks increase their desired free reserves. Thus, given the