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Relationship between the central bank and the treasuryProposal for ceiling on growth rate of money by Guy Debelle and Stanley FisherCentral banks initially started out to handle the sovereign's financial affairs and issue a national currency. That endowed them with competitive advantages that led naturally to becoming lenders of last resort to commercial banks. Because such lending created moral hazard and the risk of loss, they also became those banks' supervisors. Only later did monetary policy—managing economic growth and inflation—become a primary duty.?In the decades before the crisis, the intellectual consensus changed. Monetary policy took on more of the trappings of a quasi-scientific discipline: the judicious adjustment of the short-term interest rate could keep inflation low and thus iron out the bumps of the business cycle.? A few years before the crisis, a political consensus had emerged: central banks should be run by technocrats, free of interference by government, pursuing one goal, price stability, with one tool, short-term interest rates. The goal of ensuring financial stability took a back seat. Since the financial crisis in 2007 central banks have expanded their remits, either at their own initiative or at governments' behest, well beyond conventional monetary policy. They have not only extended the usual limits of monetary policy by buying government bonds and other assets. They are also taking on more responsibility for the supervision of banks and the stability of financial systems (this is in a sense a return to their past!). Their new duties require new “macroprudential” policies: in essence, this means regulating banks with an eye on any dangers for the whole economy. And their old monetary-policy tasks are not getting any easier to perform. Central banking is becoming a more complicated game.The connection then, as now, between interest rates and inflation may not have been exact, but at least central banks had plenty of theory and evidence to guide them. In contrast, the effects of today’s unconventional monetary policy, such as bond purchases (QE), are largely unknown. Proponents argue that with interest rates at or near zero, it is a sensible way of keeping credit flowing and preventing deflation. Opponents say that it bails out profligate treasuries and risks recreating the speculative bubbles that led to the financial crisis in the first place. With more tasks, central banks need more tools. Short-term rates are too blunt an instrument to deal with the many threats that a financial system may face. Hence the interest in macroprudential policy. If a bubble in share prices or property threatens the whole economy, better to prick it surgically rather than bludgeon everyone with higher interest rates. Central banks in emerging markets have long used tools of this kind to control credit growth and capital flows. For instance, they vary reserve requirements (cash that commercial banks must keep on deposit at the central bank) or impose quantitative limits on bank lending. Central banks in richer countries have not used them for many years, considering them ineffective, distorting or both.---The Reserve Bank of India (RBI) has made no bones about its view that monetary policy in India has been constrained by the central government’s policies. It has, in numerous policy statements, called for a change in both the quantity and the quality of the fiscal deficit. The ham-handed response of the government has been to suppress structural inflation by subsidies and administered prices, rather than do the hard work required to increase supply. The upshot is a higher fiscal deficit, which in turn leads to higher inflation---While it is a commonly accepted fact that the independence of the treasury and the central bank is desriable, academic literature does not decisively establish that more independence is better than less. The key argument favoured by the proponents of central bank independence is that discretionary policy, led by the treasury/ government, will have an inflationary bias (think of Phillips curve- to boost employment and output, incumbent government will end up increasing inflation). However, central banks might have a tendancy to swing to the other extreme- sacrificing potential output for an extended period of time simply to ensure price stability. Thus, a central bank can be ‘too independent’ to be socially optimal.Independent central banks also suffer from the problem of dynamic inconsistency- game thoeretic models can show that it is optimal ex-ante for the central bank governors to act in a manner that suggests that inflation is going to be low. If this is credible, and if inflationary expectations in the economy are thus ‘anchored’ at a low level, the central banker will have an incentive to loosen monetary policy to boost growth (think of Keynesian labour supply and demand curves- in this case, only the Ld curve will expand out!). The solution to the problem of dynamic inconsistency comes not from central bank independence, but by steadfast adherence to a monetary policy rule/ contracts for central bankers. The empirical literature on central bank independence shows a significant negative correlation between average inflation over 10-year periods and a measure of independence among developed countries. However, the coefficient on this measure is positive, although not significant, in a regression that also includes less developed countries. In discussing central bank independence, it is useful to draw a distinction between goal independence and instrument independence. A central bank has goal independence when it is free to set the final goals of monetary policy. Thus, a central bank with goal independence could, for instance, decide that price stability was less important than output stability and act accordingly. Goal independence is related to the concept of political independence; however, by political independence they mean the central bank’s ability to pursue the goal of low inflation free of political interference. A bank that has instrument independence is free to choose the means by which it seeks to achieve its goals. The Reserve Bank of New Zealand, whose goals are precisely described in a contract with the government, has no goal independence; however, it has instrument independence since it chooses the method by which ittries to achieve the pre-assigned goals. A central bank whose task was specified as attaining a given growth rate of the money stock would have neither goal nor instrument independence.“It’s not as if central banks have covered themselves in glory since breaking loose of their political masters. Inflation targets are habitually missed or undershot. Central banks not only failed to spot the sub-prime crisis, they arguably made matters worse by keeping interest rates too low for too long and thus stoking the credit bubble. And yet, governments have rewarded central banks for these failings by handing them even more responsibility for prudential and financial regulation.”Another oft-cited argument against CBI is that it is anti-democratic; however, that argument is fallacious, because government delegates all sorts of technical decisions all the time. And central bank heads can be removed if they go on a ‘tyrannical spree’.(FOCUS ON PROPOSED MPC FOR THE RBI HERE- THERE IS A VERY HIGH LIKELIHOOD OF A QUESTION) ................
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