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Issues in Central Bank Finance and Independence

  • Ã…ke Lönnberg
  • Peter Stella
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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 government. While a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy the idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation is a relatively novel idea considered in this paper. 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 maintaining 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 and/or forcing them to abandon policy objectives.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/37.

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    Length: 41
    Date of creation: 01 Feb 2008
    Date of revision:
    Handle: RePEc:imf:imfwpa:08/37
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    1. Jeanne, Olivier & Svensson, Lars E O, 2004. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," CEPR Discussion Papers 4599, C.E.P.R. Discussion Papers.
    2. Peter Stella, 1997. "Do Central Banks Need Capital?," IMF Working Papers 97/83, International Monetary Fund.
    3. 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.
    4. Charles Goodhart, 1999. "Myths About the Lender of Last Resort," FMG Special Papers sp120, Financial Markets Group.
    5. Alain Ize, 2007. "Spending Seigniorage: Do Central Banks Have a Governance Problem?," IMF Staff Papers, Palgrave Macmillan, vol. 54(3), pages 563-589, July.
    6. Alain Ize, 2005. "Capitalizing Central Banks: A Net Worth Approach," IMF Staff Papers, Palgrave Macmillan, vol. 52(2), pages 289-310, September.
    7. G. A. Mackenzie & Peter Stella, 1996. "Quasi-Fiscal Operations of Public Financial Institutions," IMF Occasional Papers 142, International Monetary Fund.
    8. Jean Tirole, 2006. "The Theory of Corporate Finance," Post-Print hal-00173191, HAL.
    9. C.A. Sims, 1999. "The Precarious Fiscal Foundations of EMU," DNB Staff Reports (discontinued) 34, Netherlands Central Bank.
    10. Alfred Broaddus & Marvin Goodfriend, 1996. "Foreign exchange operations and the Federal Reserve," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-20.
    11. Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.
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