Question

The following questions deal with the structure of central banks. a. Should central banks be independent? Briefly list and discuss two (2) arguments, as discussed in class, to support your argument. b. What do we mean by the ‘dual mandate’ of the Federal Reserve Bank? Why does it matter? Explain using the concepts presented in the course. c. Why might deposit insurance mechanisms (like the FDIC) encourage banks to take on too much risk? Is deposit insurance, then, a bad idea? Briefly explain.

Answer 1

a. Yes the Central Banks must be independent. Politicians worldwide are concerned only with remaining in power. They will do whatever it takes to remain in command as long as they can. It can therefore be said that politicians ' activities are regulated by political cycles. During the pre-election years, they become highly generous and accommodating. On the other side, the company works on a business cycle basis. It is not essential to coincide with the political cycles with periods of boom and bust. Politicians may also have a conflict of interest if they do. For example, if there is too much inflation during an election year, politicians might simply skip the choice to implement rate hikes that is essential but unpopular. Hence, it is likely that the politicians will end up jeopardizing the entire economy for selfish gains. That's why central banks must be autonomous. They can take tough decisions regardless of the election cycle.

Controlling inflation is the central bank's main goal. To do so, the money invested by the government must be controlled. If the government can make economic choices, they will only take populist choices. For example, governments may decide to provide free advantages for health care and pension, although they do not have the economic resources to enforce such choices. The bottom line is that if the government is given control over the economy, they may resort to indiscriminate printing of cash that will eventually lead to economic collapse. This is the reason why central banks need to be independent

b. Since 1977, the Federal Reserve has operated under a mandate from Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates"— what is now commonly referred to as the Fed's "dual mandate." The idea that the Fed should pursue multiple goals can be traced back to at least the 1940s, however, with shifting emphasis on which objective should be paramount. It has also been acknowledged for a lengthy time that such a mandate can sometimes generate tensions for monetary policy.

c. Introduction of deposit insurance banks are more likely to initiate riskier loans: loans with ratings higher than one, the best rating. As expected these loans carry higher contractual interest rates and are more likely to have overdue payments or default than loans with the best rating

Each bank is evaluated a proportion of its total deposits to pay for FDIC security. Regardless of prior bank records, that proportion is the same.

As a consequence, banks can create reckless loans and receive greater interest rates than conservative banks. These banks, without paying more, are more likely to benefit from the fund.

Ultimately, the FDIC promotes moral hazard because it improves the probability of what it actually insures against.