Editor’s Note: As the debate over how best to manage monetary policy heats up, the once-sharp difference between advanced and emerging economies is blurring. In a Finance & Development article, Eswar Prasad discusses the complexities of central banking in a financial crisis and the challenges central banks face in the aftermath. This article was originally published under the title “After the Fall”.
As the world economy ponders the lessons from the receding global crisis, a fierce debate has erupted about central banking concepts thought to have been long settled (Goodfriend, 2007). The appropriate role and mandate of central banks has come under scrutiny around the world.
Globalization has made both advanced and emerging market economies more exposed to external shocks, as their rising openness to trade and financial flows creates wider channels for cross-country spillovers of shocks. These forces have also increased the burden on monetary policy. It is much harder now for a central bank to use instruments such as interest rate changes to attain domestic objectives; as capital sloshes around the globe it can create many difficulties in managing monetary policy, especially in economies with shallow financial systems. And yet, monetary policy is gaining importance as a first line of defense against external shocks and breakdowns in the financial system, because it can be far more nimble than other macroeconomic policy tools.
This has generated a rich debate: what the right framework is for monetary policy, what the scope of a central bank’s objectives should be, and what the optimal degree of central bank independence is. Even as clarity about optimal monetary frameworks has diminished, a remarkable outcome of the crisis has been a convergence in the nature of the debates about central banking in economies at different stages of economic and institutional development.