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Central banks worldwide often find themselves between a rock and a hard place. The rock is price stability (inflation control) and the hard place is economic growth and employment. Although in the long run the two goals are perfectly compatible, in the short run, they sometimes are not. In those instances, the central bank has a difficult decision to make. Should it raise interest rates or slow or even stop MS growth to stave off inflation, or should it decrease interest rates or speed up MS growth to induce companies and consumers to borrow, thereby stoking employment and growth? In some places, like the European Union, the central bank is instructed by its charter to stop inflation. “The primary objective of the European System of Central Banks,” the Maastricht Treaty clearly states, “shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community” including high employment and economic growth. The Fed’s charter and the Dodd-Frank Act of 2010, by contrast, give the Fed a triple mandate to ensure price stability, maximum employment, and financial stability. Little wonder that the Fed has not held the line on inflation as well as the European Central Bank (ECB), but unemployment rates in the United States are generally well below those of most European nations. (There are additional reasons for that difference that are not germane to the discussion here.)
When central banks act as a lender of last resort (LLR) to restore stability to the financial system, they create a time inconsistency problemWhenever somebody’s preferences change over time to such an extent that what is preferred at one time becomes inconsistent with what is preferred at another time.. Can you identify what it is? (Hint: It involves moral hazard.)
It is believed that if a central bank or other lender of last resort, like the International Monetary Fund, steps in too often, it creates a moral hazard problem because businesses, including banks, take on extra risks safe in the knowledge that if the system gets in trouble, prompt and effective aid will be forthcoming. This is time inconsistent because, by stopping one panic or crisis, the central bank plants the seeds for the next.
Do note that almost nobody wants 100 percent employment, when everyone who wants a job has one. A little unemployment, called frictional unemployment, is a good thing because it allows the labor market to function more smoothly. So-called structural unemployment, when workers’ skills do not match job requirements, is not such a good thing, but is probably inevitable in a dynamic economy saddled with a weak educational system. (As structural unemployment increased in the United States, education improved somewhat, but not enough to ensure that all new jobs the economy created could be filled with domestic laborers.) So the Fed shoots for what is called the natural rate of unemployment. Nobody is quite sure what that rate is, but it is thought to be around 5 percent, give or take.