Brew-Up Ideas Winning Entry- The Need for Central Banks to Work Together

The Need for Central Banks to Work Together

Author: Priya Jain(Fore School of Management)

Past trends have shown a pattern of steady lowered interest rates being followed by the major central banks around the globe, indicating expansionary monetary policy. This can provide a short term relief in the manner of a boosting economic growth rate, however it could also be the reason for an impending financial crisis.

The slightest reduction in interest rates can help boost exports of a nation, but this not only weakens the currency but also puts pressure on the financial sector of that country. Chronic low rates may also cause people to worry about their future retirement and thus induce them to save more which goes starkly against the original purpose of the monetary stimulus. It might create an environment which reduces demand, followed by weakened economic growth.

This situation considered at a worldwide level, draws a gloomy and worrying picture. No single country has the power to enable the world to move away from this trap. So what can be done? The necessary inspiration can be drawn from the economic concept of Traveler’s Dilemma.

 

A group of travelers is returning home with identical pottery purchased during the trip. However, they find that it has been damaged in transit and demand compensation for the same. The manager of the airline, in order to find the right amount to be compensated, asks all of them to write down the price ranging from $2 to $100 – without interacting with each other. This can give us two scenarios which have been explained below:

On the face of it, this may seem easy, as all the travelers can write $100 and receive that amount as a compensation. But consider this, if all write $100 and one of them writes $99, he will get $99+$2 (the reward), i.e., $101, whereas the rest will get $99-$2 (the penalty), i.e. $97. This traveler realizes that maybe someone else has already written $99, so I better make it $98. But thinking maybe someone else has already done that he considers making it $97 and the process goes on. In the end, trapped by this rationale, everyone ends up writing, and receiving $2.So how is this related to the situation faced by the banks and lowered interest rates?

Banks have been lowering rates and this has been paving the road to global economic recovery, but soon this will be the root cause of a financial crisis. Similar to the traveler’s dilemma, banks gain by keeping the interest rates low, but if this is followed by all banks collectively, it leads to an inevitable trap. Which brings us to the need for central banks to work together taking into account the concept of altruism and drawing motivation from the moral of Traveler’s Dilemma which shows us how acting in one’s own interest is not always the best policy and can often, if not always, leave us with non-optimal results.

 

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