Question

In: Economics

The following questions deal with the structure of central banks.

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.

Solutions

Expert Solution

Answer 1(a) :-

Arguments in favour of independence of Central Bank :-

1) Politicians can end up jeopardizing the economy during election times to control rate hikes . To prevent their selfish actions , the Central Banks are required to be independent do that they can take tough decisions regardless of the election cycle.

2) If government control prevails over the Central Bank they might resort to indiscriminate money printing which will ultimately lead to economic collapse.

3) If government is allowed to involve in central bank decisions , they will only take populist decisions adversely affecting the economy.

4) Central banks are kept independent because if government was allowed to interfere in monetary policy , they would have frequently indulged in deficit spending.

Arguments against the independence of Central Bank :-

1) The biggest problem with the independence of Central Bank is that it's operations become secretive.

2) Independence of Central Banks may lead to their favourism towards big banks .

Answer 1(b) :-

Since 1977, the US Congress has established two key objectives for monetary policy in the Federal Reserve Act :-

1) Maximising employment .

2) Stabilising prices.

These two objectives are known as Federal Reserves Dual Mandate .

Dual Mandate Policy serves as an important step because :-

1) It fosters healthy economic conditions.

2) To keep a control over inflation rates .

3) Proper regulation of the labor market.

Answer 1(c) :-

Deposit Insurances are Bank programs that compensates depositors when a bank fails . Deposit insurances reduces Bank runs and panics since deposits are insured .

However Deposit Insurances exacerbates moral hazard in banking and increases chances of future Bank failures because even if a bank becomes insolvent , it's depositors do not care and does not take out their deposits from the bank .

As the chances of Bank run reduces , it induces the managers to make very risky gambles leading to the net worth becoming negative before the bank closes .


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