Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2005:21: Central bank power is a matter of faith

Ingemar Bengtsson ()
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Ingemar Bengtsson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: This paper reconsiders how central banks get involved in the process of determining nominal variables such as market interest rates and inflation rates. It is argued that the traditional story deriving central bank power from its monopoly of issuing base money is flawed. That story - in its various guises - is based on the quantity equation. This equation, however, is only applicable in the hypothetical only-cash-world, i.e. in a world where all transactions has to be paid for with central bank issued notes and coins. Nevertheless, the vast majority of economists would agree that, in practice, central banks seem to influence interest and inflation rates. Here, we suggest that the explanation is that central banks have acquired a role as focal point for those variables. It is possible because interest setting is a coordination game, in which agents have to predict each others expectations.

Keywords: Central Banking; Focal Points; Inflation; Monetary Policy; Money; Quantity Theory

JEL-codes: C70; E31; E42; E43; E44; E51; E52; E58

18 pages, March 4, 2005

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