DP11402 | Designing Central Banks for Inflation Stability

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07/21/2016

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Abstract

Well-designed central banks can uniquely determine a stable inflation rate following either active Taylor's rules or interest-rate pegs. They should receive an initial transfer of capital, hold only risk-free assets, rebate their income to the treasury. This system prevents permanent liquidity traps and inflationary spirals without further need of treasury's support beyond the initial capitalization. Instead, if the central bank engages in purchases of risky securities, fiscal support is required to uniquely back the value of money. Absent treasury's support and with a risky composition of assets, inflationary spirals and deflationary traps can develop due to self-fulfilling expectations or credit events.