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Issues in central bank finance and independence

  • Peter Stella
  • Åke Lonnberg
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    Conventional economic policy models focus only on selected elements of the central bank balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an "independent" central bank assumes that it chooses money (or an interest rate) unconstrained by a need to generate seignorage for itself or the government. Whereas a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy, this paper considers the relatively novel idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation. If one accepts this potential constraint as a valid concern, the financial strength of the central bank as a stand-alone entity becomes highly relevant for ascertaining monetary policy credibility. We consider several strands of evidence that clearly indicate fiscal backing for central banks cannot be assumed, and hence financial independence is relevant to operational independence. First, we examine 135 central bank laws to illustrate the variety of legal approaches adopted with respect to central bank financial independence. Second, we examine the same data set with regard to central bank recapitalization provisions to show that even in cases where the treasury is nominally responsible for keeping the central bank financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided central banks with genuine financial support on a timely basis, leaving them excessively reliant on seignorage to finance their operations or forcing them to abandon policy objectives.

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    Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2008-13.

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    Date of creation: 2008
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    Handle: RePEc:fip:fedawp:2008-13
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    1. Alain Ize, 2005. "Capitalizing Central Banks: A Net Worth Approach," IMF Staff Papers, Palgrave Macmillan, vol. 52(2), pages 289-310, September.
    2. G. A. Mackenzie & Peter Stella, 1996. "Quasi-Fiscal Operations of Public Financial Institutions," IMF Occasional Papers 142, International Monetary Fund.
    3. Peter Stella & Ulrich H. Klueh, 2008. "Central Bank Financial Strength and Policy Performance; An Econometric Evaluation," IMF Working Papers 08/176, International Monetary Fund.
    4. Eric Parrado & Luis Ignacio Jácome, 2007. "The Quest for Price Stability in Central America and the Dominican Republic," IMF Working Papers 07/54, International Monetary Fund.
    5. Olivier Jeanne & Lars E.O. Svensson, 2004. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," NBER Working Papers 10679, National Bureau of Economic Research, Inc.
    6. Peter Stella, 1997. "Do Central Banks Need Capital?," IMF Working Papers 97/83, International Monetary Fund.
    7. C.A. Sims, 1999. "The Precarious Fiscal Foundations of EMU," DNB Staff Reports (discontinued) 34, Netherlands Central Bank.
    8. Alfred Broaddus & Marvin Goodfriend, 1996. "Foreign exchange operations and the Federal Reserve," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-20.
    9. Alain Ize, 2006. "Spending Seigniorage; Do Central Banks Have a Governance Problem?," IMF Working Papers 06/58, International Monetary Fund.
    10. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
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