Challenging the Contemporary Role of Central Banks Written by Siyaduma Biniza* The role of central banks is focused on inflation-targeting

and currency protection. This is quite different from the historical role of central banks which was more extensive and developmental focused. This changing of the role of central is firstly a consequence of the international dominance of neoliberalism. Secondly, this changed role is characteristic of a deeper ideological and scholarly disjuncture on the growth and the efficiency of markets. This disjuncture is mostly characterised by mainstream and heterodox views on growth and inflation. The mainstream view is that central banks can only pursue economic growth at the cost of inflation. Whereas, the heterodox view is that central banks can pursue economic growth whilst avoiding hyperinflation. Considering these aspects of the current role of central banks this paper discusses whether central banks should focus on inflation of support employment and economic development. Early central banks in now developed countries typically evolved from private banks that were granted access to subsidised credit in return for performing some functions. Some of these functions include issuing national currency, being a commercial and a state bank, being the lender of last resort, providing monetary policy to maintain foreign reserves, price level, and economic activity, and offering credit towards state objectives (Epstein, 2007). Moreover, central banks historically played distributive, political and allocation roles (Epstein, 2007). This means that central banks can affect the class distribution in an economy. Central banks also played an integral role in strengthening currencies and sovereignty (Epstein, 2007). historically had a far more extensive role. Thus, central banks

However, the role of central banks has changed dramatically. The purposes above, which are direct uses of central bank policy for macroeconomic outcomes, have changed to more indirect uses of central bank policies through macroeconomic fundamentals (Epstein, 2005). Therefore central banks now practice monetary policy that targets macroeconomic objectives through fundamentals such as interest rates, inflation and money supply. These policies are intended to achieve macroeconomic goals such as promoting economic growth through indirectly means such as the impact of these fundamentals on investment. Thus the current approach emphasises the reliance on market mechanisms which is seen as the best practice for central banks (Epstein, 2005). This evolved role of central banks that has resulted in central banks orientation towards markets is a consequence of the dominance of neoliberal economics. Firstly central banks have come under the influence of institutional reform associated with credibility policy. This means that central banks have had to undertake certain policy to fit into the criteria of credible policies that are aligned with investment and the possibly resulting economic growth. In other words, over the Washington Consensus era, which led to the reduction of the role of the state, the independence of central banks has increasingly become a prerequisite for the credibility of monetary policy which is necessary for investor confidence (Grabel, 2000). This separation of the central bank from the state and politics has reformed central banks into inherently neoliberal institutions. The result has been the dissolution of central banks historically political role through the use of central bank independence as a criterion for policy credibility; which is often used as precondition for private investment. This has become the first tenet of central banks best practice amongst with other characteristics that fit within the neoliberal agenda.

Associated with this is the emphasis on inflation-targeting. In developing economies, the World Bank (WB) and International Monetary Funds (IMF) have been the stalwarts of this narrowing of central banks prerogatives (Grabel, 2000). Following economic crises these international financial institutions would impose economic programming in return for financial assistance to developing economies in distress. Together with the independence requirement, the IMF and WB would orchestrate institutional reform in central banks through educating central bank authorities in best practices which emphasised a focus on inflation fighting (Grabel, 2000). Inflation-targeting and other neoliberal policies that constituted the structural adjustment packages were often taken as a prerequisite for economic development and recovery in many developing economies (Epstein, 2005). Yet none of these policy packages have resulted in favourable macroeconomic outcomes in the developing economies. Nevertheless, inflation-targeting was again reinforced through the credibility theory which often associated policies that served the interest of private investors with policies that would lead to economic development and growth (Grabel, 2000). Hence, the adoption of rule-based practices such as inflation-targeting, which serves the interest of private investors, has been reinforced as a required policy for economic development and growth. Thus, inflation targeting was used a requirement for credible macroeconomic policies that would attract private investors towards developing economies. Again, this is characteristic of the dominance of neoliberal economics. But this is also characteristic of a deeper underlying ideological battle about the impact of inflation on economic growth. The theoretical foundations of inflation targeting originate from a seminal speech by Michael Friedman. Friedman (1968) argued that monetary policy cannot be used to control interest rates for any extended time-period nor can it be used to control the

unemployment rate for any extended time-period. According to Friedman, the mechanisms through which monetary policy can affect both interest and unemployment rates have been misunderstood. The misunderstanding stems from a conflation between real and nominal quantities and analyses that are not timesensitive (Friedman, 1968). So the central bank controls only nominal quantities, i.e. its liabilities in the form of bonds, and it cannot control real quantities such as the real interest or unemployment rates, real GDP, real growth rate or the real growth rate of the quantity of money (Friedman, 1968). These real quantities are consequences of immediate and delayed consequences of monetary policy. Thus, although monetary policy can affect these quantities it cannot control them and it can only influence the real quantities in the short run (Friedman, 1968). This means that monetary policy can be used to curb economic shocks (Friedman, 1968). Therefore, monetary policy can be used to affect nominal interest rates which are useful as an economic incentive for certain economic activity such as saving or holding money. This means that in cases of lack of confidence in the banking or financial system, the central bank can adjust expectations by manipulating the nominal interest rate or the nominal quantity of money in the economy; to induce saving or stimulate spending. Secondly, monetary policy can be used as a backbone for economic stability. Monetary policy can affect the stability of prices which signals and reinforces the stability of the economy allowing for greater economic activity. Stability of prices of prime importance for most economy activity in a capitalist system; but this is only useful as a way of affecting preferences for technological and spending changes (Friedman, 1968).

Lastly, monetary policy can be useful in offsetting major economic shocks that arise from non-monetary sources (Friedman, 1968). For example monetary policy can be useful to offsetting major inflation as a result of unrestrained government spending and a rising budget deficit. Monetary policy can be used to induce reduced spending and increased savings or debt-servicing. Thus, monetary policy can be used to control the extent of nominal quantities, as a backbone for economic stability and to curb major economic disturbances. The significance of Friedman on the direct and content of the debate on the role of monetary policy and central banks is clear given this summary of his contribution. This is why the focus of central banks has been on price stability since Friedmans work convincingly argued that monetary policy cannot affect things like long-term growth. Therefore, the mainstream approach has become an understanding of the impact of monetary policy that is consistent with the Phillips curve. The idea is that central banks should only concern themselves with short-term economic stability which is done through nominal quantities such as the interest rate. The assertion is that central banks can influence aggregate demand through interest rate which affects consumers liquidity preferences. In other words, if there is low aggregate demand and high unemployment, the central bank can reduce the interest rate which increases the demand for money. This would affect consumers liquidity preferences in that the cost of borrowing would be cheaper and the demand for money would increase whilst the demand for assets such as bond decrease; this would result in higher aggregate demand which can decrease unemployment in the short-run (Friedman, 1968). However in the long-run, when prices can adjust to the changes in aggregate demand, the result would be that aggregate demand increase only relate to increases in price levels which does not result in any changes in unemployment (Friedman, 1968).

Thus, the mainstream conclusion is that growth only occurs at the cost of inflation in the long-run. This makes it seem as though growth and inflation are incompatible and that monetary policy that pursues targets besides inflation would only lead to some growth in the short-run at the cost of inflation; which is seen as inimical to economic growth. Moreover, the assumption is that growth, unemployment and reduction in poverty will be an automatic consequence of macroeconomic stability which is reduced to price stability (Epstein, 2007). But empirical evidence shows that different policy recommendations can be made when we separate between levels of inflation. A study by Bruno and Easterly shows that, if we separate between normal inflation and hyperinflationary, the relationship between inflation and growth is less determinate. For low inflation there is an indeterminate relationship between inflation and economic growth (Bruno & Easterly, 1998). But growth cannot be sustained under hyperinflation (Bruno & Easterly, 1998). This means that growth can be achieved with inflation whilst avoiding hyperinflation. This is the heterodox view that central banks can pursue economic growth whilst avoiding hyperinflation. At low to moderate level of inflation the negative association of inflation and growth are not as robust (Bruno & Easterly, 1998). This discredits the mainstream view that is built on the premise that inflation is inimical to growth and that central banks should only pursue inflation-targeting to avoid the negative impact of inflation on economic growth. However, the mainstream thesis is true when we look at hyperinflation such growth cannot be sustained with high levels of inflation. The consequence of this is that the best practice of central banks, which is a fundamentalist pursuit of price stability, is unfounded and that this might actually be at the expense of growth.

Furthermore, even though macroeconomic stability is a necessary condition for sustained economic growth, price stability is not the only way to pursue macroeconomic stability. The narrow view of what constitutes macroeconomic stability is unfounded given the indeterminate relationship between growth and low to moderate levels of inflation. This suggests that certain levels of inflation might conducive to economic growth. Moreover, central banks should be blindly pursuing economic growth through inflation-fighting when inflation can actually stimulate economic growth. Thus central banks should not just pursue inflation targets at the expense of growth. Moreover, given that employment and poverty reduction are also vital towards macroeconomic stability, central banks should expand their mandate in co-operation with governments to include such objectives and move away from financial conservatism; if their main purpose is to stimulating economic growth and development (Sen, 1998; Epstein, 2007). But a relaxation of central bank policy or the extension of central banks mandates is unlikely given the dominance of neoliberalism which throttles economic growth with its independence requirement on central banks and the best practices of inflationfighting. This is because; the use of credibility theory which reinforces the neoliberal agenda has been enshrined through best practice rules, legislation and even national constitutions at times (Grabel, 2000). But the fortunate misfortune of financial instability, which is a greater threat to economic growth than inflation, is that recent financial crises have exposed the short-comings and inadequacy of markets. Hopefully this will result in a better understanding of the role that central banks can play given that recovery from the crisis became the prerogative of central banks worldwide; which has increased the scope of central banks economic tools.

Bibliography Bruno, M. & Easterly, W., 1998. Inflation Crisis and Long-Run Growth. Journal of Monetary Economics, 41, pp.3-26. Epstein, G., 2005. Central Banks as Agents of Economic Development. Working Paper Series No. 104. Amherst: Political Economy Research Institute University of Massachusetts Amherst. Epstein, G., 2007. Rethinking Monetary and Financial Policy: Practical Suggestions for Monitoring Financial Stability While Generating Employment and Poverty Reduction . Employment Working Paper No. 37. Geneva: International Labour Organization International Labour Office, International Labour Organization. Friedman, M., 1968. The Role of Monetary Policy. American Economic Review, 58(1), pp.117. Grabel, I., 2000. The Political Economy of 'Policy Credibility': The New-Classical Macroeconomics and the Remaking of Emerging Economies. Cambridge Journal of Economics, 24, pp.1-19. Sen, A., 1998. Human Development and Financial Conservatism. World Development, 26(4), pp.733-42.

* Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.