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Central bank power is a matter of faith

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Abstract

This paper reconsiders how central banks get involved in the process of determining nominal variables such as market interest rates and inflation rates. It is argued that the traditional story deriving central bank power from its monopoly of issuing base money is flawed. That story - in its various guises - is based on the quantity equation. This equation, however, is only applicable in the hypothetical only-cash-world, i.e. in a world where all transactions has to be paid for with central bank issued notes and coins. Nevertheless, the vast majority of economists would agree that, in practice, central banks seem to influence interest and inflation rates. Here, we suggest that the explanation is that central banks have acquired a role as focal point for those variables. It is possible because interest setting is a coordination game, in which agents have to predict each others expectations.

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  • Bengtsson, Ingemar, 2005. "Central bank power is a matter of faith," Working Papers 2005:21, Lund University, Department of Economics.
  • Handle: RePEc:hhs:lunewp:2005_021
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    References listed on IDEAS

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    1. Fama, Eugene F., 1980. "Banking in the theory of finance," Journal of Monetary Economics, Elsevier, vol. 6(1), pages 39-57, January.
    2. Woodford, Michael, 2000. "Monetary Policy in a World without Money," International Finance, Wiley Blackwell, vol. 3(2), pages 229-260, July.
    3. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
    4. Goodhart, Charles A E, 2000. "Can Central Banking Survive the IT Revolution?," International Finance, Wiley Blackwell, vol. 3(2), pages 189-209, July.
    5. Charles Goodhart, 2000. "Can Central Banking Survive the IT Revolution?," FMG Special Papers sp125, Financial Markets Group.
    6. Greenfield, Robert L & Yeager, Leland B, 1983. "A Laissez-Faire Approach to Monetary Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 15(3), pages 302-315, August.
    7. Cowen, Tyler & Kroszner, Randall, 1987. "The Development of the New Monetary Economics," Journal of Political Economy, University of Chicago Press, vol. 95(3), pages 567-590, June.
    8. Benjamin M. Friedman, 1999. "The Future of Monetary Policy: The Central Bank as an Army With Only a Signal Corps," NBER Working Papers 7420, National Bureau of Economic Research, Inc.
    9. Hall, Robert E, 1982. "Monetary Trends in the United States and the United Kingdom: A Review from the Perspective of New Developments in Monetary Economics," Journal of Economic Literature, American Economic Association, vol. 20(4), pages 1552-1556, December.
    10. Friedman, Benjamin M, 1999. "The Future of Monetary Policy: The Central Bank as an Army with Only a Signal Corps?," International Finance, Wiley Blackwell, vol. 2(3), pages 321-338, November.
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    Cited by:

    1. Bengtsson, Ingemar, 2005. "A framework for understanding inflation - with or without money," Working Papers 2005:28, Lund University, Department of Economics.
    2. Bengtsson, Ingemar, 2005. "Transaction Costs, Money and Units of Account," Working Papers 2005:29, Lund University, Department of Economics.

    More about this item

    Keywords

    Central Banking; Focal Points; Inflation; Monetary Policy; Money; Quantity Theory;

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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