The central bank Goals, targets and instruments

The central bank Goals, targets and instruments

Historic goals of central banks The central banks of different countries usually have their own distinctive and somewhat different sets of goals in their mandates from their respective legislative authorities. However, as we shall see in this section, there is also a high degree of similarity in the goals, broadly defined, among them. Further, the mandate assigned to a given central bank is normally broad enough to allow it a great deal of latitude in the goals it does choose to pursue in practice. We illustrate the types of goals usually assigned to central banks by looking at those for the USA, Canada and the UK. Original mandate of the Federal Reserve System in the USA The Federal Reserve System, referred to as the Fed, is the central bank of the United States. It was set up in 1913 and has a Board of Governors3 with a Chairman at its head. Its monetary policy is set by the Federal Open Market Committee (FOMC), which consists of the Board of Governors and five of the presidents of the twelve Federal Reserve Banks. FOMC sets the Federal Funds rate, which is the rate at which commercial banks trade reserves with each other through overnight loans. A publication of the Federal Reserve System of the USA listed the broad objectives of the system as: To help counteract inflationary and deflationary movements, and to share in creating conditions favorable to sustained high employment, stable values, growth of the country, and a rising level of consumption. It might have also added the additional objective of promoting a favorable balance of payments position. The list of economic goals in the mandates assigned until the 1980s to most central banks was very similar to the above multiplicity of goals. Original mandate of the Bank of Canada The Bank of Canada was set up in 1934. It has a board of directors and a Governor, who decide on monetary policy. The preamble to the Bank Act of 1934, setting up the Bank of Canada, stated that the mandate of the Bank was to be:

To regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada. This preamble required the Bank of Canada to use monetary policy to achieve multiple goals. There was an implicit assumption behind the preamble that it was within the Bank’s power to affect not only the rate of inflation and the exchange rate, but also the real – and not merely the nominal – variables of output and employment. On the latter, the assumption was that the Bank could affect the short-run values of these real variables and thereby influence their fluctuations. Evolution of the Bank of England and the goals of monetary policy in the UK The Bank of England was founded as a private commercial bank in 1694.4 Although a privately owned bank until 1946, it acted from the very beginning as the banker for the British government, under a business arrangement entered into in exchange for large loans made by the Bank to the British government through its purchase of government bonds. It was given the monopoly of (future) note issue in 1844, when it also withdrew from commercial banking. Its notes were made legal tender and convertible into gold at a fixed exchange rate. It evolved into a central bank through custom and practice in the eighteenth and nineteenth centuries, only gradually increasing its responsibility for maintaining orderly conditions in the money markets and influencing the policies and practices of the other commercial banks. Given its origin as a private bank and its gradual evolution in practice into a central bank, there was no explicit legislated mandate for the Bank of England to pursue monetary policy in order to achieve specific national macroeconomic goals, even though it interacted closely with the government. Its primary goals through the eighteenth and nineteenth centuries seemed to be mainly related to maximizing its own profits and preserving its own solvency. This was consistent with the tenor of traditional classical ideas, which did not possess a theory of monetary policy for manipulating the economy and did not espouse an active monetary policy for stabilizing it. Since the nationalization of the Bank of England in 1946, the relationship between the Bank of England and the government – represented by the Chancellor of the Exchequer, who is the government minister in charge of the Treasury – has gone through two distinct phases. From 1946 to 1997 the government had statutory power over not only the goals but also the use of instruments of monetary policy, though the day-to-day operations and the normal business were left to the Bank. The Bank made recommendations to the Chancellor, who had the final decision on the goals being pursued. The Bank implemented the policies defined by the Chancellor, though with some discretion over the timing of implementation of decisions. Consequently, the goals pursued for the economy through monetary policy were ultimately those of the government and depended upon the preferences of the party in power. In 1997, however, the Bank was given operational independence in implementing monetary policy, but the power to set the ultimate goals of monetary policy was retained by the Chancellor and, therefore, by the government. Given this division of powers in Britain between the Bank of England and the government, it is appropriate to use the term “monetary authority” to encompass both of them in their joint roles of setting the goals and pursuing the implementation of monetary policy. By comparison, in the United States and Canada, the monetary authority will simply be their respective central banks. In practice, the historic goals of the monetary authority in theUKwere very similar to those of the central banks in the USA and Canada. From 1946 to the early 1980s, these policies were based on a wide set of goals, including lower unemployment, higher growth, lower inflation and the maintenance of the exchange rate, under the notion that it was possible to achieve several goals or at least trade off among them through monetary policy. Mandate of the European Central Bank The gradual bonding of the European countries during the postwar years and their eventual merger into the European Union in the 1990s resulted in their monetary unification in that decade. The central element of this unification is the European System of Central Banks (ESCB), established under the Maastricht Treaty of 1992. The ESCB consists of the European Central Bank (ECB), based in Frankfurt, and the national central banks of the member countries, and is federalist in structure. The central decision-making body on monetary policy is the ECB’s Governing Council, composed of the national central bank governors5 and the Executive Board6 of the ECB. The Executive Board, besides running the day-to-day operations of the ECB, carries out the decisions of the Governing Council and coordinates their implementation by the national central banks in their respective countries. Since the European Central Bank was set up recently, its mandate reflects current thinking on monetary policy. Its charter states that the “primary objective” of the European System of Central Banks (ESCB) should be to “maintain price stability.” The charter also establishes the complete independence of the ECB and the national banks from their various governments, so that they are protected from having to take instructions from governments. The ESCB uses changes in interest rates as the main operational tool of monetary policy, but continues to attach importance to the evolution of monetary aggregates, especially M3, as a guide for its policies. Additional mandates of the central banks in the LDCs Most less-developed countries are unable to raise the revenue internally to cover their fiscal, with the result that they continually incur large fiscal deficits. Some of these tend to be covered by foreign borrowing by the government, but very often there is still a remainder that needs to be financed. While such deficits in the richer and financially developed nations are normally covered by the government borrowing directly from the public through the issue of short- and long-term bonds, the financial markets in the LDCs are too thin to support much governmental borrowing. Given this constraint, many governments in the LDCs rely upon the central bank to directly finance the remaining deficit through increases in the monetary base, or to do so indirectly by the sale of government bonds to the central bank. Hence, while the LDCs have broadly similar mandates for their central banks as in the industrialized countries, an additional one in practice is that of financing the fiscal deficit. The justification sometimes given for this is that of national interest. In some cases, the deficit is related to massive development programs, so that the central bank’s financing of the deficit is further claimed to be a contribution to national economic development. However, such a practice makes monetary policy subservient to fiscal policy, and has implications for the independence of the central bank from the government and for its control of inflation. 11.2 Evolution of the goals of central banks Revision in economic theory and the implied limitation on goals The 1970s were a period of expansionary monetary policy but were accompanied by stagflation in Western economies. This combination produced a period of increasing doubts about the relevance and validity of Keynesian policy presсrіptions, which, in turn, proved to be a fertile ground for the emergence and acceptance of resurgent neoclassical theories. An early element in this resurgence was in the revision of the Phillips curve to the expectationsaugmented Phillips curve (see Chapter 14), often associated with Milton Friedman. Friedman (1977) argued that there was a short-run trade-off only between the unemployment rate and the deviation of the inflation rate from its expected level. But there was no longrun trade-off between unemployment and inflation. Hence, monetary policy had a very limited ability to change the unemployment rate. The 1970s also saw the introduction of the hypothesis of rational expectations. Lucas, Barro, Sargent and Wallace, Kydland and Prescott and others in the 1970s and 1980s laid the foundations of the modern classical model with rational expectations and the neutrality of systematic monetary policy as its core elements (see Chapters 14 and 16). Only random monetary policy could affect short-run output but such a policy would be meaningless. Systematic increases in money supply, under conditions of symmetric information between the monetary authority and the public, would be anticipated but could not bring about the deviation of employment from its equilibrium level. In the 1980s, the impact of this theoretical revision in the scope of monetary policy was to persuade the central banks of many countries to abandon the multiplicity of goals in favor of a heavy and sometimes sole focus on controlling the rate of inflation. While formal legislative revision of the traditional mandates of the central banks was rare, in practice there was a considerable reduction in the emphasis on using monetary policy to change unemployment and output. The primary goal of monetary policy became a low inflation rate and the resulting policy became one of “inflation targeting.” The success of the inflation targeting policy since the 1980s in reducing inflation on a long-term basis, accompanied by increasing output and employment, has led to a general adoption of inflation targeting as the primary objective of central banks in many countries. As of 2002, inflation targeting had been adopted in 22 countries, including Canada and New Zealand (which had started this policy), the UK and the USA. However, the objective of ensuring full employment has not disappeared, since both inflation targeting and output targeting are components of the popular Taylor rule (see Chapters 12 and 13) for setting interest rates. Evolution of the goals of the monetary authorities in Britain As discussed earlier, the British monetary authority from 1946 to the early 1980s possessed a multiplicity of goals. While the goal of price stability had been one of those goals and had received increasing emphasis by the end of the 1980s, the sole focus on it was made explicit in 1992 when the Chancellor of the Exchequer announced the adoption of explicit inflation targets (1 percent to 4 percent) aimed at achieving long-term price stability. This adoption of an explicit target for the inflation rate represented an explicit abandonment of other goals such as those on unemployment and output growth, exchange rate stability and business cycle stabilization. The Chancellor and the Bank periodically set the inflation target. The official inflation target was changed in 1995 by the Chancellor, with the agreement of the Bank of England, to a point target of 2.5 percent. It is currently (2008) at 2 percent, along with a set range for acceptable fluctuations in inflation. The primary objective of monetary policy in Britain is now explicitly that of price stability and only secondarily growth and employment objectives. The implementation of monetary policy, such as the setting of the Bank rate, since 1997 has been left to the Bank and its Monetary Policy Committee. Goodhart (1989, 1995) provides an excellent statement of central banking from a British perspective. Evolution of the goals of the Bank of Canada In the late 1980s, the Governor of the Bank of Canada publicly argued that the mandate of the Bank should be changed to focus only on price stability as its mandated goal. The proposal was considered in 1992 by a parliamentary committee, which decided to leave the Bank’s mandate as it had been specified in the Bank of Canada Act of 1934, i.e. with a multiplicity of goals. However, several successive Governors of the Bank in the late 1980s and the 1990s have advocated and in practice consistently focused solely or mainly on the goal of price stability or a low inflation rate. Since 1991 the Bank has announced explicit targets, with an average of 2 percent and a range of 1 percent to 3 percent, for the core inflation rate. These targets have been set jointly by the Bank of Canada and the Government of Canada.7 Movements in other variables such as the exchange rate and asset prices are taken into account to the extent that they affect the rate of current or future inflation. In the case of a deviation of the actual inflation from the 2 percent target, the Bank normally aims at bringing inflation back to its target over a six to eight-quarter period. The Bank uses a Monetary Conditions Index (MCI) (explained later in this chapter), which is a weighted sum of the interest rates and the exchange rate, as an operational guide. It uses the overnight loan rate for reserves as its operational target, with a range of 50 basis points. The Bank Rate – on its loans to banks and some other financial institutions – is now set at the upper limit of the target range. New Zealand’s experiment on the goal of price stability New Zealand was the first country to explicitly adopt inflation targeting. After an extended period of double-digit inflation for much of the late 1970s and 1980s, as well as unsatisfactory growth, major legislative changes were made to the country’s monetary arrangements in the mid-1980s and in 1990. Among these was the grant of a limited degree of independence to the central bank, the Reserve Bank of New Zealand, to formulate and implement monetary policy so as to maintain price stability. However, on the formulation of the goals of monetary policy, it required the Minister of Finance and the Governor of the central bank to jointly establish the specific inflation target, its range and the inflation index to be used for the target. This information is communicated to the public. These agreements are renegotiated at certain intervals and leave a measure of flexibility in meeting changing economic conditions. The target ranges for inflation were 3–5 percent from 1990 to 1992, 0–2 percent from 1992 to 1996 and 0–3 percent since 1996. Permissible breaches of the established target are allowed in special circumstances, such as natural disasters, changes in indirect taxes and significant relative price shocks. The Reserve Bank of New Zealand currently uses the Monetary Conditions Index, a concept pioneered by the Bank of Canada. This index is a weighted sum of an interest rate measure and the exchange rate, and is used as a guide for monetary policy. The New Zealand pattern is similar to that in Britain, and to some extent that in Canada. Its central bank has operational independence but not total independence over the ultimate goals of monetary policy. The goal is limited to that of price stability by legislation, and the legislation requires that the target range be set jointly with the government.8 Recent pattern of the goals of monetary policy in the United States The pursuit of goals by the Federal Reserve System changed in the 1980s and 1990s in a manner similar to that in the other countries discussed above, from the pursuit of multiple goals during the pre-1980 period to that of price stability. One difference between the Fed and the British and Canadian monetary authorities is that the Fed does not set explicit targets for the rate of inflation, though its pursuit of a low rate of inflation consistent with price stability is not in doubt and is often asserted by the chairman of the Board of Governors of the Fed. Taylor (1993) argued that the Fed had effectively moved to a monetary policy rule (see the Taylor rule later in this chapter and in Chapters 12 and 13) incorporating inflation targeting. The Fed is more genuinely independent of the United States’ President and government than are the Bank of England or the Bank of New Zealand of their governments, in terms of both the formulation of its goals and their pursuit through its monetary policies. There is no question of the government issuing formal instructions to the Fed on the further pursuit of monetary goals or instruments, of requiring it to write open letters to the government explaining its actions, or of penalties being imposed for a failure to achieve price stability. Instruments of monetary policy The central bank pursues its monetary policy through the use of one or more of the instruments at its disposal. The mix of the instruments used depends upon the structure of the economy, especially the financial system, and tends to depend on the stage of development of the bond and stock markets. The most common instrument among developed countries is often the change in interest rates, which is usually supported by open market operations. 11.3.1 Open market operations Open market operations9 are the purchase (or sale) by the central bank of securities in financial markets, resulting in corresponding increases (decreases) in the monetary base.10 Countries with well-developed financial markets and extensive amounts of public debt traded in the financial markets usually rely on such operations, which, along with the shifting of government deposits between the central bank and the commercial banks, are the most important tool for changing the money supply. However, this does not hold a corresponding position among the countries around the world since its prominent position requires certain preconditions to be met. The most important of these are: 1 The financial structure of the economy should be well developed, with most of the borrowing and lending being done in the organized financial markets of the country itself. 2 There should be a relatively large amount of the securities of the kind that the monetary authorities are willing to purchase. These are often, though not always, government securities. A large public debt is thus generally essential. 3 The financial system and markets of the country should be broadly independent of those of other countries. Very open economies with perfect capital flows and fixed exchange rates do not possess such independence. To take an extreme example, different states or regions within a country do not possess an independent financial system and cannot pursue a monetary policy independent of the country. Similarly, members of a currency or monetary bloc with fixed exchange rates among the member countries cannot pursue monetary policies independently of that of the bloc. An example of such a bloc is the European Union with fixed exchange rates among the national currencies of the member countries. Financially underdeveloped economies generally fail to satisfy the first condition. Individual countries in an economic and/or political union, such as the European Union, may not fully meet the third condition, so that their national central banks cannot independently pursue such operations, but may do so in support of the monetary policy set by the central bank of the overall union.11 Many countries of the world fall into one or more of these categories. Even in the United States, open market operations were rarely used prior to the Second World War. Most countries pursue other tools of monetary policy, to supplement, or as an alternative to, open market operations. Shifting government deposits between the central bank and the commercial banks The central bank almost always acts as the government’s bank, keeping and managing the government’s deposits. Increases in these deposits with the central bank through payments by the public to the government out of their deposits in their commercial banks reduce the monetary base, whereas decreases in such deposits because of increased payments by the government to the public increase the monetary base. One way of avoiding changes in the monetary base because of payments to the government or receipts from it, is for the government to hold accounts with the commercial banks and use them for its transactions with the public. The resulting increases and decreases in government deposits with the commercial banks do not change the monetary base, but transfers of these deposits to the central bank reduce this base. In Canada, the Bank of Canada manages the distribution of government deposits between itself and the chartered banks in Canada as a way of manipulating the monetary base and therefore as a tool of monetary policy akin to open market operations. In current practice, such shifting of balances is more convenient and has become more important than open-market operations for changing the monetary base over short periods. Reserve requirements The imposition of reserve requirements12 has historically been a common tool of controlling monetary aggregates for a given monetary base. In cases where the markets are too thin for viable open-market operations, or the monetary base cannot be controlled for some reason, the monetary authorities often attempt to limit the creation of reserves by the banking system through the imposition of, or changes in, reserve ratios against demand deposits and sometimes also against other types of deposits. These ratios can range from 0 percent to 100 percent, though they are often in the range of 0 to 20 percent, with changes in the required ratio being often of the order of 0.25 percent or 0.5 percent. Until 1980, the USA had a complex system of reserve requirements for its banks, with different requirements for banks that were members of the Federal Reserve System and those that were not, between banks in large cities and others, etc. In 1980, the US Congress imposed much greater uniformity on the depository institutions, including banks, thrift institutions and credit unions. The Fed was given the power to set the reserve requirement between 8 percent and 14 percent on transactions deposits and raise it to 18 percent in special cases. The reserve requirements on personal time and savings deposits were eliminated. In 1998, the reserve requirement was 10 percent on checkable deposits if the bank had checkable deposits above a certain amount, and 3 percent if these deposits were below this limit. There was no positive reserve requirement on non-checkable time deposits. Canada had reserve requirements of 5 percent against demand deposits in chartered banks from 1935 to 1954, though the banks often kept much higher reserves (sometimes over 10 percent). From 1954 to 1967 the reserve requirement was 8 percent, with the Bank of Canada having the power to raise it to 12 percent, though this power was never used. By the Bank Act of 1967 the required ratio was raised to 12 percent against demand deposits, with 4 percent on notice deposits in Canadian dollars, but the power of the Bank to vary them was eliminated.13 In 1980 the required reserve ratio against demand deposits was fixed at 10 percent, with lower ratios against other types of deposits. In early 1992 Canada, in an environment of a highly stable and well developed financial system, abolished reserve requirements on its banks, leaving them to determine whatever amounts of reserves they wished to hold. However, they still have to maintain non-negative settlement balances with the Bank on a daily basis, with any negative balances being offset by overdrafts from the Bank at the bank rate. The average reserves held by the Canadian commercial banks are now usually less than 1 percent of demand deposits and sometimes fall as low as 0.1 percent or even lower. In Britain, after 1945, the London clearing banks, which are the main clearing banks in Britain, adopted the practice of keeping a minimum reserve ratio of 8 percent of their deposits. Changes in it were never required as an instrument of monetary policy. After 1971, the banks agreed to keep an average of 1.5 percent of their eligible liabilities (mainly their sterling deposits) in non-interest bearing deposits with the Bank of England. Even this requirement was eliminated in 1981, so that the reserve requirement in Britain became zero percent. In 1999, the average ratio of the banks’ non-interest bearing deposits with the Bank of England to the sterling deposits placed with them was about 0.15 percent. The difference between the reserve requirements in Britain and Canada versus those in the USA is illustrative. Part of the reason is historical patterns. But part is also due to the nature of the British and Canadian banks, which tend to be large and countrywide with few failures in the past. Both countries display sufficient confidence in the solvency of their banks to eliminate positive reserve requirements. Although some of the US banks are among the largest in the world, many, if not most, of the US banks are relatively small, confined to a state or a region, with a pattern of bank failures among such banks. Higher reserve requirements contribute to their solvency and the public’s confidence in them. Table 11.1 shows the reserve requirements in 1998 in the G-7 countries, along with the length of the averaging period. As Table 11.1 shows, there are considerable variations in the reserve requirements among this group of countries. However, the countries with large oligopolistic banking systems tend to have very low, almost zero, reserve requirements. All countries allow some averaging period for meeting the reserve requirements, though it is only one day in the British case. Without averaging, or with averaging over only one day, the daily shocks to the banks’ deposits and consequently their demand for liquidity result in sharp movements in the overnight interest rates, unless the central bank can manage to monitor these daily and to Table 11.1 Reserve requirements, 1998 UK USA Germany France Italy Japan Canada Required ratio zero 3–10% 1.5–2% 0.5–1% 15% 0.05–1.3% zero Length of averaging period 1 day 2 weeks 1 month 1 month 1 month 1 month 4–5 weeks effectively offset the results of such shocks. Since it is not possible to do so on a daily basis in many countries, averaging over several weeks is the general pattern. In the Western economies, changes in the required reserve ratios are now either no longer available as an instrument of monetary policy or not used in practice for this purpose. 11.3.3 Discount/bank rate In most countries, the monetary authority – normally the central bank – has the power to determine, directly or indirectly, the interest rates in the economy.14 Critical interest rates can be set directly by fiat, determined through instructions issued to the commercial banks, or influenced indirectly by the central bank varying the rate at which it lends to the commercial banks. In the more usual case in market-oriented economies, the market rates are influenced through the discount rate at which the central bank lends to the banks and other designated financial intermediaries and by the market overnight loan rate for reserves. Canada, the UK and the USA have traditionally followed this method. The use of interest rates as the major operating instrument of monetary policy occurs because interest rates play a pivotal intermediate role by which investment and therefore aggregate demand in the economy can be influenced. Further, it is argued by some economists that the economy has numerous substitutes for M1 and M2,15 so that controlling these aggregates through open-market operations or the reserve requirements of commercial banks only leads to substitution away from them, without necessarily a significant impact on investment and aggregate demand.16 Further, in recent years, because of numerous financial innovations, the demand functions for money have proved to be unstable, so that many central banks prefer to target interest rates, and influence them through their discount rate, rather than target monetary aggregates as the main operational tool of monetary policy. Chapters 10 and 13 provide the justification for this policy for controlling aggregate demand if the shocks are mainly from the monetary sector rather than from the commodity one. The central bank, in setting or changing its discount rate, indicates its willingness to let the commercial banks determine the extent of borrowing from it and thereby changing the monetary base in the economy. Its target for the overnight loan rate for reserves determines the rate at which commercial banks borrow from each other. Any announced changes in these rates act as indicators of the bank’s future intentions about the economy’s interest rates that it will support through its open-market operations, and therefore serve as an indicator of the future stance of monetary policy. The commercial banks and other financial intermediaries usually, though not always, follow the lead given by the discount and the overnight loan rate changes to alter their own interest rates17 – such as the prime rate, the personal loan rates and the mortgage rates – as well as in their purchases and sales of market instruments. This behavioral pattern results in a shift of the interest rates throughout the economy, while leaving the spread between any pair of rates to market forces. Conversely, the central bank’s refusal to change these rates in the face of rising market rates serves to dampen the latter. This discount rate is called the bank rate in Canada and the UK. In the UK, as explained earlier in this chapter, since 1997 the Bank of England, through the Monetary Policy Committee, has had the operational independence to set this rate. Until 1971, a sort of cartel arrangement among the British commercial banks linked the market interest rates on various types of bank deposits to the bank rate. The abolition of this cartel in 1971 made the market rates more responsive to market forces, though the bank rate set by the Bank of England still continues to be the core rate for the financial markets and changes in it are the major operational instrument of monetary policy. Since the British banks as a whole need to achieve balance at the end of each day, the Bank of England can choose on a daily basis the interest rate at which it will provide additional funds to the banking system. Changes in this rate prompt the banks to change the base rates at which they lend to their customers, so that the changes in the Bank’s own lending rate cascade through the various interest rates in Britain. In Canada, the bank rate (at which the Bank of Canada lends to commercial banks) was set by the Bank until 1980. In the 1980s and the early 1990s, it was fixed at 1/4 percent above the 91-day Treasury bill rate at its weekly auction of government bonds. Since it was above the Treasury bill rate, it was considered to be a “penalty” rate in the sense that it imposed a net loss on the borrowing bank, which had the option of obtaining the needed funds more cheaply by selling from its holdings of Treasury bills. The Bank influenced the Treasury bill rate through its own bids for Treasury bills. Since 1994, the Bank has been setting the overnight loan rate – that is, the rate on trades in reserves – with a band of 50 basis points, as an operational target. Since 1996, the bank rate has been set at the upper limit of the operating band specified for the overnight loan rate. Setting the bank rate at this upper limit makes borrowing from the Bank more expensive than in the commercial market for reserves and is meant to persuade commercial banks to meet their reserve needs through their borrowing of reserves in the private markets. However, borrowing from the Bank is treated as a right of the banks rather than a privilege. In any case, the Canadian banks consider borrowing from the Bank of Canada as sending out a signal that they have liquidity problems and are reluctant to resort to such borrowing. Any advances are normally for only a few days and often overnight. In the United States, the discount rate is frequently below the market short interest rates. Since banks can make a profit from borrowing from the Fed and then buying market instruments, keeping the discount rate below the market rates becomes an incentive for commercial banks to borrow from the Fed. However, the Fed treats borrowing from it as a privilege rather than a right. Frequent borrowing from the Fed can lead to its refusal to lend again and would invite closer scrutiny of the borrowing bank’s accounts and policies. Further, a bank may view its borrowing as a signal to the public that it is in dire financial need and is not able to conduct its affairs properly, so that it may be reluctant to borrow.18 A change in the discount rate can serve as an instrument of monetary policy in three respects: 1 It affects the amount of borrowing – which changes the monetary base and the money supply – from the central bank. 2 Changes in it – or lack of a change when one was expected – act as a signal to the private sector of the central bank’s intentions about monetary policy. 3 The central bank’s control over its discount rate provides it with considerable control over the interest rates in the economy. The latter two are now the relatively more important reasons for the use of the discount rate as an instrument of monetary policy. Central bank as the lender of last resort Borrowing from the central bank at the discount rate is associated with the notion of the central bank acting as the lender of last resort in the economy. While commercial banks with inadequate reserves can borrow from those with surpluses, a reserve shortage in the financial system as a whole cannot be met in this manner and could force the economy into a liquidity and credit crunch. The discount window – i.e. the ability to borrow from the central bank – is therefore a “safety” valve for the economy. The discount window also acts as a safety valve for an individual bank that needs reserves but is unable or unwilling to borrow from private financial institutions. However, in the United States, borrowing from the central bank invites the scrutiny of the central bank into the borrowing bank’s management of its affairs and acts as a disincentive to frequent borrowing from the central bank, as against borrowing in the market. Further, banks are not permitted to make chronic use of the discount window for meeting liquidity needs. Discount rate and interest rate differentials in the economy The central bank’s power to set its discount or bank rate does not extend over the differentials or spreads among the various interest rates in the economy. In particular, the spreads between the commercial banks’ deposit rates and the short-term market rates, such as on Treasury bills and money-market mutual funds, are still outside the direct influence of the central bank and depend upon market forces. From the perspective of monetary theory, the determinants of the demand for M1 and other monetary aggregates are critical for the impact of monetary policy. These demands would depend on both the levels and the differentials among interest rates. Since the latter are mainly outside the influence of the central bank, the impact of the changes in the discount rate on the demand for monetary aggregates is correspondingly reduced. 11.3.4 Moral suasion Moral “suasion” – rather out-of-date term for “persuasion” – refers to the use of the influence of the central bank upon commercial banks to follow its suggestions and recommendations, such as in exercising credit restraint or diverting loans to specified sectors of the economy. Such suggestions do not possess the force of law, though the threat of converting suggestions into legal orders, if necessary, often backs such suggestions. Moral suasion generally works well in countries with a very small number of large banks and with a long tradition of respect for the judgment and extra-legal authority of the central bank. Although both the UK and Canada are good examples of this, the Bank of England is especially known for its extensive use of moral suasion. However, moral suasion is not generally appropriate for the large and diverse banking system of the United States, though it has been tried sometimes. An example of the latter occurred in 1965 when the President and the Federal Reserve laid down guidelines to limit foreign borrowing. This was fairly well adhered to by the member banks, but represented a rare usage of this tool in the USA. This term is also sometimes associated with the rules imposed by the Fed on banks that attempt to borrow too frequently from it and is, therefore, associated in the US with the use of the discount window. 11.3.5 Selective controls Selective controls are those with impact on certain sectors rather than upon the overall economy. A common example of these is credit controls. The usual reason for such controls is that social priorities may differ from private priorities. Thus the government may wish to divert funds to exports, housing, agriculture, state and local governments and to industries believed to be essential to national development. This can include giving special rediscounting privileges to private commercial export bills. Some central banks also favor housing and agriculture through favorable discount provision and direct credit controls, with such support provided under the regulations and guidelines given by the central bank to the commercial banks. However, such support in the United States, Canada and the UK is generally fiscal, in the form of tax exemptions, subsidized loans from the government, etc., rather than being an aspect of monetary policy. Another reason for selective controls is to curb the destabilizing nature of certain sectors or to use the critical position of certain sectors for stabilization purposes. For example, on the former, the Federal Reserve limits the stock market credit extended by banks and brokers on the purchase of securities by setting minimum-margin requirements. These specify the minimum down payment at the time of purchase. This requirement was, for example, 70 percent in 1968 for stocks registered on national security exchanges, so that purchasers of such stocks could borrow only up to 30 percent of the purchase price from banks or brokers. The Federal Reserve can raise these requirements up to 100 percent. Another example of such controls is those on consumer credit. These often specify, for designated durable consumer goods, the minimum down payment at the time of purchase and the length of time over which the balance has to be paid. Such controls are exercised in some countries and often go under the name of installment-credit or hire-purchase controls. In the USA, the Fed was given the power to impose such controls in the Second World War, in the Korean War and briefly in 1948–49, but does not now possess such a power. 11.3.6 Borrowed reserves Funds borrowed by commercial banks from the central bank are called borrowed reserves. Those acquired through their sale of securities or through the deposits with them by the public are called non-borrowed reserves. The distinction between borrowed and non-borrowed reserves is important since commercial banks usually are less willing to lend as high a proportion of the former as of the latter. This occurs since the former are borrowed for short periods and carry the discount rate, which is usually higher than the commercial paper rate. In addition, there is often a reluctance to borrow, or to borrow repeatedly, since banks view doing so as creating doubts in the public’s mind about the borrowing bank’s ability to manage its affairs properly. There is, therefore, often a stigma attached to such borrowing. Repeated borrowing also invites closer oversight, which is considered undesirable, by the central bank and other regulatory authorities of the bank’s investment policies. The central bank can vary the amount borrowed from it by varying the discount rate. A decrease in this rate, relative to market interest rates, makes it more tempting for banks to increase their borrowing. As against borrowing from the central bank, banks can borrow reserves from each other at the Federal Funds rate in the overnight loan market for reserves; this is called the Federal Funds market in the USA. This market enables banks to lend their excess reserves to other banks that are short of reserves. The central bank controls both its discount rate and the overnight loan rate. The central bank manages the latter by open-market operations in the reserves market; an open-market purchase of bonds by the central bank increases the reserves traded in this market and reduces the rate. To sum up, individual banks can borrow reserves in the overnight loan market from other banks that have excess reserves, through repurchase agreements with the central bank, or from the central bank at the discount rate. 11.3.7 Regulation and reform of commercial banks In addition to its control of the economy through monetary policy, a major function of central banking and its related regulatory authorities is to ensure the continued health of the financial system as a whole and of the individual banks. The latter can involve various types of regulations, such as restrictions on the amount of credit and the payment of interest,20 restrictions on the type of investments that the financial institutions can make, etc.21 11.4 Efficiency and competition in the financial sector: competitive supply of money 11.4.1 Arguments for the competitive supplies of private monies It is a major contention of economic theory that production and exchange are at their most efficient in perfectly competitive markets. Hence, social welfare is maximized by having perfect competition in all sectors, including the financial one. Even if the actual markets cannot be made fully competitive, restrictions on competition are damaging to efficiency. These tenets are applicable not only to the markets for consumer and investment goods but also to the financial markets. As a corollary, some economists have argued that the financial markets would be most conducive to maximizing the economy’s output if they were free from administrative regulations on the products that financial institutions can supply and the prices they charge for these. The products supplied by the financial sector are essentially types of financial intermediation, and involve the holdings of assets and the issue of liabilities by the financial intermediaries. The prices involved are interest rates in the financial markets and service charges, etc. imposed by financial intermediaries. Hence, microeconomic theory implies that the various types of financial institutions should be allowed to compete with each other in the various financial markets, such as for demand deposits, savings and time deposits, mortgages, the purchase and sale of shares, mutual funds, trusts management, pension funds, insurance, etc. Some economists extend this argument to the proposal that the issue of money should also be left unregulated and that there is no need for a central bank.22 In fact, since the existence of such a bank with its issue of fiat money represents monopoly power over one aspect of money, its existence and the supply of fiat money reduce social welfare. In line with this argument, it is proposed that private, competitive firms should be allowed to issue coins and notes. It is further argued that the power of commercial banks to create inside money in the form of demand deposits and other types of near-monies should not be limited by any imposition of reserve requirements. Nor should there be regulations on the interest rates charged, on ownership, limitations on the encroachment of banks on trust companies, insurance companies, etc., by limiting the products they can supply. As we have mentioned above, the basis for such proposals is the application of the principle of Pareto optimality of perfect competition to the provision of monies and other financial products. Arguments for the regulation of the money supply While economists generally accept the propositions on the promotion of competition among the firms in the financial sector, few economists accept the proposals on the abolition of the central bank, on the elimination of its power to issue fiat money or on the elimination of its power to monitor and regulate the financial system to ensure its continued health, etc. The basic reason for this stand is that the health and stability of the monetary sector is considered to be vital to the prosperity and functioning of the macroeconomy. Further, variations in the supply of money are taken to have a strong impact on the real sectors of the economy. The commercial banking system is inherently fragile and based on trust by the depositors in the viability of the institutions in which they hold their deposits. A purely competitive and unregulated system is prone to fluctuations in the degree of this trust and therefore susceptible to runs by depositors concerned about the security of their deposits. Two basic reasons for this are the fractional reserve practices of banks and their policy of borrowing short and lending long. Since banks keep reserves, in cash or in deposits with the central bank, equal to only a small fraction of their deposits, they cannot at short notice meet a sudden attempt by depositors to withdraw their deposits in cash. This is further exacerbated by the portfolio policies of banks under which large proportions of their assets are in bonds, mortgages, loans, etc., which are difficult to convert into cash at short notice or can only be cashed with significant losses. Individual banks may also be tempted to engage in high-risk investments, with a consequent possibility of losses, which create a loss of confidence in the bank accompanied by a run to withdraw deposits from it. Given this inherent fragility of a purely private competitive banking system, several measures are taken to ensure the continuation of a high level of confidence in the banking system. One of these is the insurance of individual deposits, usually to a pre-set limit, by a central deposit insurance agency. Another is having a central bank that attempts to anchor the supply of privately created inside money in the economy through its own issue of fiat money, and also attempts to control variations in the aggregate money supply in the national interest. In addition, the central bank tries to ensure confidence in the financial sector through its regulation and monitoring of financial intermediaries, especially commercial banks since they supply the most liquid financial assets in the economy and are the creators of inside money. Focusing first on the supply of fiat money by the central bank, one reason for its issue by the central bank is to anchor the privately supplied demand and other types of deposits and therefore the money-supply aggregates in the economy. Another reason concerns the seigniorage – that is, the revenue – emanating from new issues of the monetary base. The central bank is a national institution and its profits are added to the fiscal revenues, so that it seems to be the obvious recipient of such seigniorage. Further, in many low-income economies, seigniorage can be a significant proportion of national revenues and are needed for financing government expenditures. 11.4.3 Regulation of banks in the interests of monetary policy From the perspective of the central bank, an important aspect of its activities is its regulation of the financial institutions in the economy. Part of this regulation is aimed at the control of the money supply in the national macroeconomic interest. Another part is aimed at maintaining a sound financial system and encouraging, if necessary, its growth to fit the financial needs of the economy. This supervision often takes the form of regulations on the ownership of such institutions, forms of liabilities issued, the kind of assets held and the auditing of their accounts. Such supervision is only of minor interest from the standpoint of macroeconomics provided it is successful in maintaining a stable and adequate financial system. But it is often a substantial part of the activities of the central bank and its related agencies, and can be critical for the solvency and efficiency of the financial system of the country. Monetary economics is closely concerned with those regulations of the monetary authorities that affect the liquidity of the economy, especially as reflected in the monetary aggregates. As discussed earlier, among these regulations the central bank often specifies the minimum reserves that commercial banks must maintain against demand deposits. The interest rate at which commercial banks can borrow from the central bank is also set by the central bank rather than based purely on a market mechanism. There may also be other conditions imposed on such borrowing. The maximum interest rates that commercial banks may themselves pay on various kinds of deposits are also, in some countries, set by the central bank. There may be, and often are, other areas of regulation of commercial banks’ behavior. The basic reason for the close regulation of commercial banks lies in the fact that they issue demand deposits that are a major part of the money supply, no matter how it is defined. Most of the regulations governing commercial banks are, in fact, aimed at regulating their creation of demand deposits, with the aim of bringing the total amount of demand deposits and hence the total money supply within the control of the central bank. Historically, banking in the British tradition arose under a set of customary practices and imposed rules that restricted commercial banks to the issue of demand and savings deposit liabilities and the holding of short-term government bonds as assets. Banks were thereby confined to the highly liquid end of the spectrum of financial assets, leaving other specialized financial institutions to the markets for mortgages, insurance, trusts, pension funds, etc. In addition, there were also restrictions on bank ownership by non-bank corporations, as well as on the ownership of the latter by the banks. This pattern began to change in the second half of the twentieth century, both in the issue of bank liabilities and in their portfolio of assets.23 The changes became more pronounced during the 1980s and 1990s, with the financial institutions increasingly being permitted to expand into other than their traditional financial markets, as well as to own or be closely associated with financial institutions in other markets. These changes allowed commercial banks to issue mutual funds, act as investment brokers for the buying and selling of shares, sell insurance and manage pension funds – and conversely to allow firms formerly engaged in these markets to offer banking services. The result by the end of the twentieth century was a breakdown in the USA, Canada and Britain of the barriers between types of financial institutions, mergers and eventually larger sizes of the financial firms, as well as much more aggressive competition in the financial markets. An aspect of the limitations on banks had been the regulation of the interest rates that banks could pay on the demand and savings deposits placed with them. Often this was an attempt to prevent too aggressive a competition for deposits and to ensure the solvency of banks. An example of this was Regulation Q in the USA during the 1950s and 1960s, under which ceilings were imposed by the Federal Reserve on the interest rates paid by its members on deposits, while many other financial institutions were not subject to such limits. In the interests of promoting competition and removing discriminatory restrictions on banks, such ceilings were first gradually raised and then eliminated in the 1970s and 1980s. The imposition of ceilings on interest rates paid by banks is now rare in financially developed economies, and such ceilings do not exist in Canada, the UK or the USA. But they do exist in many countries, especially among the LDCs. 11.5 Administered interest rates and economic performance Manipulating interest rates as guidance to monetary policy or as an aspect of short-term stabilization policies is quite different from setting them over long periods in order to achieve some long-run objectives.Amongsuch objectives is that of attempting to increase the long-run growth rate of the economy. Interest rates represent the cost of investment, which is the increase in the capital stock of the economy and an essential requirement for the growth of the economy’s output capacity. Hence, it can be argued that low rates of interest imply higher investment and therefore higher growth rates for the economy. Many countries, especially LDCs, in the second half of the twentieth century, followed this reasoning to set interest rates in the organized markets of their economies below what would have been determined in unregulated markets. These rates were usually not adjusted to the rate of inflation, so that the interest rates that could be charged often fell below the inflation rate, thereby implying a negative real rate of return on loans. Interest is not only the cost of funds borrowed for investment, it is also the return on savings lent through the financial markets. Neo-classical theory posits a positive relationship between them, so that lower rates of interest imply lower saving. However, the empirical significance of this dependence of saving on interest rates is in considerable doubt. If saving in practice does not depend on interest rates, while investment does so, it could be argued that keeping the rates of interest low would promote growth of the economy on a net basis. Interest rates, however, also play the role of allocating funds between the various projects and sectors of the economy. With interest rates below their levels for clearing the markets for loans, administrative mechanisms come into play to allocate the limited funds to the greater demand for them. Among these mechanisms are governmental or central bank regulations on the sectors, projects or firms that are to be given credit, rules of the banks themselves, favoritism of bank managers, etc. Corruption often becomes rife in such a context and becomes a basis for the granting of loans. The end result is the misallocation of funds to projects and firms, in which the most productive uses do not always or adequately get the funds. Such misallocation is detrimental to the growth of the economy. Conversely, leaving the interest rates to be determined in the open and competitive markets for loans promotes the efficient allocation of savings to the variety of investments and thereby increases the growth of the economy. This realization by many LDCs in the 1980s and 1990s led to the “liberalization” of interest rates – a term for lifting ceilings or setting them free to be determined by market forces – in many of them. Such freeing of the interest rates from administrative control is very often part of the broader “liberalization” of the economy, through deregulation and decontrol of exchange rates, imports and exports, production and investment, etc., and has resulted in many cases in increasing the growth rates of those economies. While all economies have an informal financial sector in which borrowing and lending take place other than through the established and regulated financial intermediaries, such a sector in the LDCs is larger and more significant relative to their formal financial sector. This sector is not only outside the purview of central bank control and policies, its spread between the deposit rates and the loan rates is usually much larger than in the formal sector. The low deposit rates discourage saving while the high loan rates discourage borrowing for productive investments. Therefore, while the informal sector is vital to the economies of the LDCs, policies which force savers and borrowers to the informal sector through restraints on the formal sector tend to reduce saving and investment in these economies. This implies a recommendation for the competitive and efficient expansion of the formal sector relative to the informal one, though not necessarily through statutory restrictions on the latter. 11.6 Monetary conditions index In 1992, the Bank of Canada defined a Monetary Conditions Index or MCI, which is a weighted average of short-term interest rates and the trade-weighted exchange rate of the Canadian dollar. Roughly, a change in the MCI24 is specified as: MCI ＝ R+(1/3)ρ where R is the short-term nominal interest rate, interpreted as the 90-day commercial paper rate, and ρ is the effective exchange rate, interpreted as the exchange rate for the Canadian dollar against the 10 major (G-10) currencies. The reason for the one-third weighting of the exchange rate relative to the interest rate is the Bank of Canada’s belief, based on empirical work done therein, that a change in interest rates by 1 percent has three times the impact of a corresponding change in exchange rates on aggregate demand in the Canadian economy. Given that the effect is in the same direction for both R and ρ, opposite changes in these variables offset each other’s effects on the economy. Hence, if an increase in the exchange rate occurs and if the Bank considers the resulting increase in the MCI to be undesirable, the Bank responds by inducing a sufficient offsetting reduction in interest rates to keep the MCI unchanged. Alternatively, it can act to manipulate the exchange rate, though it normally does not do so. The MCI is used as a guide for the Bank’s policies. The Bank formulates its expectations on the state of the Canadian economy and those of its major trading partners, decides also on the desired rates of inflation and growth in aggregate demand, and determines the target values of MCI that would achieve these goals. Monetary aggregates, along with other macroeconomic variables, are used as information variables. The Bank does not specify a target path for the MCI, nor set a target path for the exchange rate, nor try to ensure that its actions result in the specific ratio of one-third in interest rate to exchange rate changes. The MCI is used as an operational guide, but the main focus is on its goals defined in terms of aggregate demand and price stability. The Bank sets the overnight loan rate, with a range of 50 basis points, as its operational target to achieve its desired value of the MCI. It allows the financial institutions and the markets to determine the actual amounts of the monetary aggregates on the basis of the targeted overnight loan rate. Its money market operations are used to hold the overnight rate in the specified range. Movements in the overnight rate in turn induce changes in the other interest rates and the exchange rate. The Bank of Canada tries to influence the overnight rate through changes in the settlement balances25 held with it by the direct clearers, mainly the commercial banks, in the Canadian payments system. Positive amounts of these balances do not pay interest, but any negative amounts have to be covered by overdrafts at the bank rate. While such changes in settlement balances can be brought about by open-market operations, the Bank usually relies upon daily transfers of government deposits between it and the direct clearers, making such transfers and the resulting supply of settlement balances its main instrument for changing the monetary base and exercising control over the economy. The Bank of Canada believes that uncertainty is inimical to the proper functioning of the financial markets and the efficiency of the economy, and that the uncertainty of monetary policy can adversely affect saving and investment in the economy. In an attempt to reduce such uncertainty, changes in the target range for the overnight rate are immediately made known to the public, and the intended course of the monetary policy of the Bank is continuously explained to the public through publications and speeches of the Governor of the Bank and its officials. 11.7 Inflation targeting and the Taylor rule Currently, the central banks of Britain, Canada, the USA and many other countries are said to follow “inflation targeting,” which is the pursuit of an inflation target. However, in reality, they have adopted a Taylor rule (Taylor, 1993; also see Chapters 12 and 13) of the general form: rt ＝ r0 +α( yt −y f )+β(πt −πT) α,β ˃ 0 (1) where r is the real interest rate to be set by the central bank, y is real output, y f is fullemployment output, π is the actual inflation rate, πT is the inflation target of monetary policy and the subsсrіpt t refers to period t. πT is called the target inflation rate. Similarly, y f is the target output level. (yt −y f ) is (minus of) the output gap. r0 should be the long-run real interest rate. The Taylor rule embodies two objectives: stabilizing inflation at its target rate and stabilizing output at its full-employment level. While movements in the inflation rate and output are, on average, positively correlated, they are not necessarily so over short periods. Under this rule, monetary policy raises the interest rate if inflation is above target and output is above its full-employment level. Some proposals for the Taylor rule include other variables, such as the exchange rate. Note that, in practice, central banks set the nominal interest rate rather than the real one. Consequently, the Taylor rule implies that if πt −πT ˃ 0, the nominal rate would rise more than the inflation rate, and if πt −πT ˂ 0, the cut in the target real rate would mean that the nominal rate would fall more than the inflation rate. Such a policy is one of “leaning against the wind.” For any given inflation rate, the greater the value of β, the larger will be the change in the real and nominal rates and the stronger the movement to stabilize the inflation rate at its target value. While monetary policy can use either the interest rate or some monetary aggregate, or some combination of the two, central banks in Britain, Canada and the USA, as well as in many other countries, use the interest rate, rather than a monetary aggregate, as the operating target of monetary policy, though the European Central Bank also monitors movements in monetary aggregates, especially M3, as part of its formulation of monetary policy. The interest rate usually targeted by central banks is the overnight loan rate in the market for reserves, but it could also be the discount/bank rate at which the central bank lends to commercial banks. A major advantage of specifying the inflation target in the Taylor rule is that it encourages the transparency of monetary policy and anchors inflation expectations, which provides guidance for wage demands, investment plans, etc. Since the 1980s, central banks’ achievement of their low inflation targets has increased the credibility of their targets and policies, which has meant that the public’s inflationary expectations are now closely determined by the central bank’s inflation targets (see Chapter 12 on the credibility of monetary policy). Empirically, while none of the central banks has announced its form of the Taylor rule or even a commitment to it, this rule has performed quite well in econometric studies for Britain, Canada and the USA, as well as for many other countries. Its use has been credited with a reduction in inflation from high levels during the 1970s and 1980s to the current low levels. It has also been credited with reductions in the volatility of inflation since the 1980s (Clarida et al., 1998; Sims, 2000; Moreno and Rey, 2006). Chapters 13 and 15 provide further discussion and references on the Taylor rule. 11.8 Currency boards Some countries, more so in the past but rarely nowadays, had currency boards instead of central banks.26 With a currency board, the country maintains a fixed exchange rate against a designated foreign currency, and the monetary base – a liability of the currency board – is backed by its foreign exchange reserves. As these reserves increase – for example, through a balance-of-payments surplus – the currency board increases the monetary base and the money supply in the economy increases. Conversely, as foreign exchange reserves fall, the monetary base and the money supply are decreased. Other than this, the currency board does not have discretion to change the money supply or manage interest rates and therefore cannot pursue domestic monetary policies. Currency boards werecommonin the colonies of imperial countries – for example, theUK– during the first half of the twentieth century. They were a means of linking the currency and economies of the colonies to those of the imperial country. Further, if the imperial currency was under the gold standard – that is, with its value fixed in terms of gold – the colonies also indirectly adhered to the gold standard. Such currency boards were usually replaced by central banks on independence. In other cases, countries, though independent, maintained currency boards with a strict adherence to the gold standard, implying a fixed value of the domestic currency in terms of gold. Note that most of the aspects of this chapter, bearing on the goals, instruments and targets of monetary policy, do not apply to currency boards. Conclusions The monetary sector is central to modern economies and its proper functioning is critical to the levels of employment, output and growth. As an illustration of this importance, it is now generally agreed that monetary failure caused, or was a major main contributor to, the Great Depression of the 1930s (Friedman and Schwartz, 1963). The central bank is the custodian of the health, efficiency and performance of the financial sector. The monetary policy pursued by the central bank is therefore fundamental to the performance of the economy. This chapter has shown that the goals and the favored instruments of central banks have varied over time and differ among countries. Currently, the dominant belief of most central banks is that they can best promote output, employment and growth through fairly stable prices. In particular, the belief is that continual or discretionary attempts to increase aggregate demand through monetary policy do not yield higher output or reduce business fluctuations over time. Further, monetary policy acts on the economy with a sufficient lag so that, with the future course of the economy being difficult to predict accurately, the proper formulation of monetary policy is an art and, as such, potentially susceptible to error. In the 1990s the dominant goal, pursued in the European Union, Canada, New Zealand, the UK, the USA, and many other countries, was that of price stability, encompassed in the notion of inflation targeting, which is the maintenance of a low rate of inflation (about 1 to 3 percent). Given the long-run neutrality of money, this goal is sometimes conveyed as an ultimate goal and at other times as an intermediate goal towards improving the growth rates of output and employment in the economy. For Canada, the European Union, New Zealand and the UK the target for the inflation rate is explicitly announced, whereas the USA does not announce – and therefore, does not give an explicit pre-commitment to – a pre-specified inflation target. However, empirical studies have shown that the Taylor rule (see Chapters 13 and 15) performs quite well for all these countries, so that the monetary policies of the central banks were not aimed exclusively at an inflation target but rather at the deviations of output and inflation from their desired long-run levels. The use of interest rates as operational targets is to be distinguished from a policy of fixing them administratively for long periods and at relatively low levels, with the ostensible purpose of promoting growth. This was done in many LDCs during the 1970s and 1980s, though there is currently a trend away from this practice. The interest rate is the opportunity cost of loans and should, for the proper allocation of funds in the economy, be determined by competitive forces in the open markets. Setting them or setting artificially low ceilings on them by administrative action introduces inefficiencies into the financial structure of the economy, inimical to the optimal generation of savings, as well as to their allocation by the financial institutions optimally to investment among the sectors of the economy.27 LDCs are especially prone to setting artificially low interest rates on loans in the organized