Central Bank Design

Before the 21th century, money was usually based on the gold standard, because in order for money to work as money, people had to have confidence in it, that it could not be manipulated by the will of politicians or banks. By using gold or some other precious metal that was scarce and had to be mined, or by allowing money to be exchanged for gold, politicians and banks could not create money at will, which was the usual cause of rampant inflation often seen in third-world countries.

The temptation to create money is very great. In the 17th, 18th, and 19th centuries, United States banks issued their own notes which, supposedly, could be exchanged for specie, which were gold or silver coins. However, many banks printed many more notes than what they had specie for, creating the booms and busts of that period. Hence, being able to exchange the money for specie was not a reliable method for controlling the supply of money because there was no way to know if the total value of the issued bank notes was equal to the total amount of specie held by the issuer.

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However, controlling the supply of money is a very useful means of controlling the economy. When managed correctly, the supply of money can be controlled to allow the economy to operate at maximum efficiency. Hence, no country relies on the gold standard anymore and, increasingly, money is becoming electronic. Electronic money is very easy to create, at virtually zero cost. Although it has many benefits, the only way that electronic money, or any money not based on any scarce resource, can work is if the economy has tight control over the supply of money according to specific objectives, which generally gives priority to low and stable inflation.

In order for a central bank to achieve these objectives, to operate successfully, and to achieve the optimization of the economy, it must have certain characteristics:

Independent And The Sole Authority for Monetary Policy

The central bank needs to be independent so that it can respond to the economy, which is the only way to optimize it. Allowing politicians to meddle invites disaster, since politicians are highly motivated to change monetary policy for short-term gains, even when the long-term effects could be disastrous. With politicians running the economy, booms and busts are inevitable, since politicians are only concerned about the next election.

For central banks to achieve independence, they must satisfy several conditions:

Decision-Making by the Monetary Policy Committee

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Although the central bank should have sole authority for monetary policy, no individual should. Hence, monetary policy is usually decided by a monetary policy committee (MPC). MPC members generally have long terms and cannot be removed from their position except for cause. Members of the committee are usually drawn from different banks and from different geographic areas so that they can provide information about their area of the economy and to provide a diversity of opinion. Generally, committee members have expertise in economics, banking, and monetary policy.

Decision-making by committee is effective for monetary policy, because it takes time to assess the response of the economy and for the economy to respond to any change in policy. Hence, there is no need for quick decisions, since haste can lead to disaster. The knowledge, experience, and opinions of a group of people reduce the risk that central bank policy will be subjected to an individual's ideology. Examples of central banks and their MPCs include:

Generally, the number of MPC members varies from 9 in the UK and Japan to 22 in Europe.

Public Policy Objectives

The central bank's policy objectives should be clear and communicated to the public, so that people will trust their financial markets and institutions to not manipulate the money supply unless it conforms to policy objectives, so that inflation will be low and stable.

Low inflation is the most important objective because it allows people and businesses to plan long-term. Furthermore, interest rates depend on low inflation, because interest rates are commensurate with future expectations of future inflation — the higher the expected inflation, the higher the interest rate demanded by lenders to compensate them for the reduced value of money in the future. Higher interest rates have the same effect as reducing the supply of money — discouraging spending and investments, and reducing employment and economic output.

Another benefit of public policy objectives is that everyone knows what the central bank is going to do. Therefore, no one gains an advantage by knowing a secret policy, since such knowledge would give an investor or business person an unfair advantage over others.

Accountability and Transparency

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Another aspect of the central bank's effectiveness is accountability and transparency. Because the voting members of the central bank are not elected officials, there must be some way to know that the central bank's policies are in the best interest of the economy, that their policies are effective, and that the central bank is actually following those policies.

Explicit goals are often defined when the central banks are created or when major laws are passed that affect their operation. Explicit goals promote accountability, in that they provide a means of measuring how effective the central bank is in carrying out its policies. Disclosure requirements create transparency, which forces the central banks to reveal how they function and to explain the rationale for their policies.

Central banks of different countries achieve accountability and transparency by different methods, more or less successfully. Virtually every central bank announces its policy actions quickly, but the details of the statements vary and the willingness to answer questions also varies. For example, the Federal Reserve is very concise in its information and does not answer any questions, while the president and vice president of the European Central Bank hold a press conference and answer questions.

Almost all central banks have their own websites, most of which have a wealth of detail about their operations and objectives. Most of them can be found at Central Bank Websites.

Accountability and transparency are also required for the central bank to maintain its independence, since there are always politicians who want to change, or even abolish, the institution. These politicians usually know little about economics, but want the changes to suit their own political objectives. For instance, Ron Paul, a longtime House Republican representing Texas and an occasional contender for the United States Presidency, wants to abolish the Federal Reserve and go back to the gold standard. It is the confidence of the people in the central bank that it is doing its job that helps to prevent politicians from changing the law to suit their own purposes and the people maintain their confidence when they are kept informed by the central bank.