Introduction

The specification of central banking functions and the institutional arrangements within which these functions are performed are open for discussion. The need for changes in central bank goals and operations in the face of the financial crisis has opened up issues which, during the Great Moderation period, had been regarded as long settled.

One of these issues concerns the goals of central banks. While inflation targeting had been applied for some time by many central banks, the new economic environment seems to many to warrant an alternative; candidates for an alternative include nominal gross domestic product (GDP) targeting, unemployment targeting, and promoting financial stability. But here we consider the merits of a range of goals pursued simultaneously, with potential conflicts addressed by means of judgment. Further, while we will emphasize the importance of the role of central banks, it will be recognized that they cannot exercise direct control, either of macroeconomic aggregates or of the financial sector. In attempting to achieve their goal(s), central banks have always had to tailor their policy instruments to the changing character and strength of financial markets. The liberalization and globalization of finance since the 1970s, and then the financial crisis, dramatically altered both the scale and sophistication of financial markets and the relationship between central banks and financial institutions. But, while such developments challenge the effectiveness of traditional instruments of monetary policy, care must be taken not to exaggerate the power previously exercised by central banks. Even before the 1970s, central banks could only influence the level of credit and money in the economy, not control it.

A further issue concerns the institutional arrangements within which central banks pursue their goals and in particular the case for central bank independence. The return of central banks to major open-market operations in sovereign debt has eroded previous efforts to separate monetary policy and fiscal policy. At the same time, central bank activities have had their own direct political consequences, including substantial redistribution of income. There are good reasons therefore to revisit the presumption that central bank independence is beneficial.