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This article appears in the following Cambridge Journal of Economics issue: Special Issue: The Global Financial Crisis [View the issue table of contents]
The limits of central bank policy: economic crisis and the challenge of effective solutions
* University of Helsinki
Address for correspondence: The Centre of Excellence in Global Governance Research, PO BOX 4 (Yliopistonkatu 3) 00014, University of Helsinki, Finland; email: zen34405{at}zen.co.uk
The paper examines the development of central bank policy prior to and during the recent financial crisis. The argument is made that it contained multiple failures that not only generated constraints on adequately identifying and addressing the crisis but also contributed to that crisis. Those failures derived from a combination of theory and institutional practice. Specifically the use of forms of inflationary targeting based on broad adherence to the Taylor rule framework and the use of versions of a Conventional Theoretical Macro Model (CTMM) were both problematic. This was particularly so in the way policy was focused through issues of the primacy of price stability. The institutional arrangements of the central banks were also problematic. The division of labour between the central banks and other regulatory bodies and the limited information available within a liberalised finance system hampered efforts to fully appreciate the gravity of the situation. Partly due to the constraints imposed by the thinking and strategies that had been developed the central banks never got to grips with the fundamental problems of the crisis. Interest rate policy and liquidity provision were undertaken in ways that steadily radicalised the approaches of the banks but always in a way that was event led and always in ways that could not resolve those fundamental problems. The nature of the crisis highlights the importance of transforming the approach and institutional framework of the central banks. Relatedly, it highlights the need for a more Keynesian and heterodox approach to economics within decision making bodies at central banks.
Key Words: Central bank policy • Taylor rule framework • Fed • Bank of England • Keynes • Interest rates • Liquidity
JEL classifications: G0, B4, P1
Manuscript received March 31, 2009; final version received May 10, 2009.
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