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    Silver Member Graeme's Avatar
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    Central Bankers

    Central Banks and the Interest Rate

    An interesting article in last week’s ‘Economist‘ :

    “Central Banks use a variety of devices to convince markets of their inflation-fighting credentials. An explicit inflation target can itself be such a device .….. and …….. the more clearly the central bank’s objective is understood and the more its good intentions are believed, the better.”

    “That a central bank has an explicit inflation target does not tell you how quickly it will try to bring inflation back into line when it has veered off course. Inflation is rarely the only thing that central banks care about. Prices do not adjust immediately, so bringing down inflation will cost output and jobs. A central bank balances deviations of inflation from the target against the output gap (the difference between output and capacity).”

    “Lars Svensson, an academic at Princeton University who has recently become a deputy governor of the central bank in his native Sweden formulates this trade-off as an equation. He supposes that the central bank wants to minimise the weighted sum of the square of the inflation gap and the square of the output gap. The relative weight given to the output gap is denoted by the Greek letter lambda. The higher lambda is the more the central bank worries about output and the longer it is prepared to take to return inflation to target. Set lambda equal to nought , and the bank could not give a jot about output; it is run by “inflation nutters”, in the phrase of Mr King, governor of the Bank of England. Set lambda equal to infinity, and inflation becomes irrelevant.”

    “The question is, how explicit can central banks be? Mr Svensson thinks that they should publish lambda if they can. Most other central banks think that although lambdas are useful theoretical devices, publishing them is unrealistic. For one thing it gives the impression that the central bank knows more about the world, or even about its own reaction function, than it really does. For another, the weight banks give to output gaps may change over time - they may set a lower lambda, for instance, when they want to establish a reputation as inflation fighters. The tight-knit world of central banking will keep a close watch on Scandinavia.”

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    Site Caretaker Dave A's Avatar
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    Quote Originally Posted by Graeme View Post
    Set lambda equal to nought , and the bank could not give a jot about output; it is run by “inflation nutters”, in the phrase of Mr King, governor of the Bank of England. Set lambda equal to infinity, and inflation becomes irrelevant.
    This makes me wonder about our own central bank - and my theory that they're operating on too narrow a mandate.

    So is our Reserve Bank an "inflation nutter"?
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    just me duncan drennan's Avatar
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    Quote Originally Posted by Dave A View Post
    So is our Reserve Bank an "inflation nutter"?
    I'm not so sure. It is a tricky one...how do you balance the two issues (inflation and growth) and still give a consistent message, as well as make it clear that you are not there to bail business out?

    From the little bit of reading I've done, it would seem that the American Fed has consistently bailed the market out when things have gone a little awry, which led to the market being almost reliant on this bailing out, and expecting it the whole time. This in turn eventually seems to have led to the whole sub-prime issue.

    I really don't have the knowledge or tools to understand all the subtleties well, but this article is probably worth the read for another perspective.
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    Site Caretaker Dave A's Avatar
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    Interesting link.
    The trouble with opportunity is it normally comes dressed up as work.

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