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Describe money and functions of money using real life examples and further describe how banks, central

banks control money-supply, money multiplication and its pros and cons. Explain all processes banks, consumers and governments follow in about sequences.

Group work by, Gohar Badalyan Caridad Morente Cadenas de Llano Merve Nasr David Babayan Teresa Picerno

15.11.2011

Outline Introduction Money


Functions of money Measuring money supply The circulation of money

Banking Banks and money supply


Money multiplication

Central Banks and Monetary Policy


Central Bank and its Functions Central Banks and Monetary Policy Control of money supply

Introduction
What is money and why everyone wants to have money? Why you can change money for some commodity? An answer to this and other questions related to money is possible to find in this paper. There were clearly described money as a universal mean, its functions and a circulation of it. Banks and banking, how central banks control the money supply and how the monetary policy works. Together with definitive and systematic explanations there were brought a real life examples related to this, which help reader to understand it more clearly.

Money
In economics the meaning of the term money is different from its everyday meaning. People often say money when they mean income or wealth, however in economics money refers specifically to assets that are widely used and accepted as payment. Historically, the forms of money have ranged candy bars, cigarettes (in World War II prisoner-of-war camps), huge wheels of carved stone (on the island of Yap in the South Pacific), cowrie shells (in West Africa), beads (among North American Indians), cattle (in southern Africa) to gold and silver. In modern economies the most familiar forms of money are coins and paper money, or currency. Another common form of money is checkable deposits; assets that can be used in making payments, such as cash and checking accounts, or bank accounts on which checks can be written for making payments. One reason that money is important is that most prices are expressed in units of money, such as dollars, yen, and euros. Money is generally divided into two groups, commodity money and fiat money. Commodity money is for example, prisoners of war made purchases with cigarettes (see Appendix1), quoted prices in terms of cigarettes, and held their wealth in the form of accumulated cigarettes. Of course, cigarettes could also be smoked, so they had an alternative use. Gold represents another form of commodity money. But, today money almost in over the World is mostly fiat money. Fiat money, sometimes called token money, is money that is basically worthless. Why would anyone accept worthless paper instead of something that has some value? It is not because the paper money is exchanged by gold or silver. There was a time when dollar bills were convertible directly into gold. If the price of gold were $35 per ounce, for example, the government agreed to sell 1 ounce of gold for 35 dollar bills. However, it is no longer like this. They are exchangeable only for dimes, nickels, pennies, other dollars, and so on. The public accepts paper money as a means of payment and a store of value because the government has ensured that its money is accepted. The government declares its paper money to be legal tender; the government declares that its money must be accepted in settlement of debts. Functions of money: Money serves four basic functions: It is a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. Not all monies serve all of these functions equally well. But to be money, an item must perform enough of these functions to make people to use it. Medium of Exchange: Money is a medium of exchange; it is given in exchange for goods and services. Sellers willingly accept money as payment for the products and services that they produce. Without money, we would have to resort to barter, the direct exchange of goods and services for other goods and services. Unit of Account: Money is a unit of account: Goods and services are priced in terms of money. This common unit of measurement allows us to compare relative values easily. If whole-wheat
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bread sells for a dollar a loaf and white bread sells for 50 cents, we know that whole-wheat bread is twice as expensive as white bread. Using money as a unit of account is efficient. It reduces the costs of gathering information on what things are worth. Store of Value: Money functions as a store of value or purchasing power. If you are paid today, you do not have to hurry out to spend your money. Or for example you buy a painting of Picasso you can store it and after some years you will store value and you will sell it much expensive. But in this case inflation plays a major role in determining the effectiveness of money as a store of value. Higher the inflation rate, lower your money purchasing power. Standard of Deferred Payment: Finally, money is a standard of deferred payment. Debt obligations are written in terms of money values. If you have a credit card bill that is due in 30 days, the value you owe is stated in monetary unitsfor example, dollars in the United States and yen in Japan. We use money values to state amounts of debt, and we use money to pay our debts. Measuring money supply: Changes in the money supply affect interest rates, inflation, and other indicators of economic wellbeing. When economists measure the money supply, they measure spendable assets. As we know, many different assets have performed this role over the centuries, ranging from gold to paper currency to checking accounts. For example, money market mutual funds (MMMFs). MMMFs are organizations that sell shares to the public and invest the proceeds in short-term government and corporate debt. MMMFs make every effort to earn a high return for their shareholders. They allow their shareholders to write a small number of checks each month. Thus, although MMMF shares can be used to make payments, they are not as convenient as cash or regular checking accounts for this purpose. But there is no definitive answer MMMF shares should be considered as money or not. To measure money, we need a precise definition that tells exactly what assets should be included. For this reason, in most countries economists and policymakers use several different measures of the money stock. These official measures are known as monetary aggregates. Today Monetary aggregates are called M1, M2 and M3 (see Table 1in Appendix 2). M1 Money Supply: The narrowest and most liquid measure of the money supply is the M1 money supply, or financial assets that are immediately available for spending. This definition emphasizes the use of money as a medium of exchange. The M1 money supply consists of currency held by the nonbank public, travelers checks, demand deposits, and other checkable deposits. Demand deposits and other checkable deposits are transactions accounts; they can be used to make direct payments to a third party. The components of the M1 money supply are used for about 74 percent of family purchases. This is one reason why the M1 money supply may be a useful variable in formulating macroeconomic policy. M2 Money Supply: The M2 money supply is a broader definition of the money supply that includes assets in somewhat less liquid forms. The M2 money supply includes the M1money supply plus savings deposits, small-denomination time deposits, and balances in retail money market mutual funds. M3 Money Supply: The M3 monetary aggregate adds to M2 somewhat less liquid assets such as large denomination time deposits, repurchase agreements, Eurodollars and institutional money market mutual fund shares. The circulation of money: Money circulates all the time. It circulates from the central banks to government to industries than to individuals and back to all. So this is very complicated system and understanding of this we will put a diagram where is shown the circulation of money (see Appendix 3).
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Banking
Commercial banks are financial institutions that offer deposits on which checks can be written. In most of all countries, commercial banks are privately owned. Thrift institutions are financial institutions. Savings and loan associations, credit unions, and mutual savings banks are all thrift institutions. Both commercial banks and thrift institutions are financial intermediaries, middlemen between savers and borrowers. Banks accept deposits from individuals and firms then use those deposits to make loans to individuals and firms. A bank is willing to serve as an intermediary because it hopes to earn a profit from this activity. It pays a lower interest rate on deposits than it charges on loans; the difference is a source of profit for the bank. Islamic banks are prohibited by holy law from charging interest on loans; thus, they use a different system for making a profit. According to Muslim holy book, the Koran, Islamic law prohibits interest charges on loan. Infect profit-sharing deposits; Islamic banks typically offer checking accounts, travelers checks, and trade-related services on a fee basis. Islamic banks have been lending money to traditional banks to fund investments that satisfy the moral and commercial needs of both, such as lending to private firms. These funds cannot be used to invest in interest-bearing securities or in firms that deal with alcohol, pork, gambling, or arms. The most popular instrument for financing Islamic investments is murabaha. This is essentially cost-plus financing, where the financial institution purchases goods or services for a client and then, over time, is repaid an amount that equals the original cost plus an additional amount of profit (see full case Appendix 4).

Banks and money supply


Banks create money by lending money. They take deposits, and then lend a portion of those deposits in order to earn interest income. The portion of their deposits that banks keep on hand is a reserve to meet the demand for withdrawals. In a fractional1 reserve banking system, banks keep less than 100 percent of their deposits as reserves. If all banks hold 10 percent of their deposits as a reserve, for example, then 90 percent of their deposits are available for loans. When they loan these deposits, money is created. Money multiplier: The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. The deposit expansion multiplier equals the reciprocal of the reserve requirement. It also tells us how much the monetary base expands to create the money supply, because Money Supply = monetary base * money multiplier Money multiplier deposit expansion multiplier = 1/required reserve ratio Required reserve ratio= reserves at bank/total deposits Money multiplier < deposit expansion multiplier, it is only if public holds currency and banks hold excess reserves. In the United States, the required reserve ratio varies depending on the size of the bank and the type of deposit. For large banks the ratio is currently 10 percent, the money multiplier will be 1/.10 = 10. This means that an increase in reserves of $1 could cause an increase in deposits of $10.Money multiplier is derived under the assumption that banks hold no excess reserves. For example, when Bank 1 gets the deposit of $100, it loans out the maximum that it can, namely

a system in which banks keep less than 100 percent of their deposits available for withdrawal

$100 times 1 minus the reserve requirement ratio. If instead Bank 1 held the $100 as excess reserves, the increase in the money supply would just be the initial $100 in deposits. The deposit expansion multiplier indicates the maximum possible change in total deposits when a new deposit is made. If banks hold more reserves than the minimum required, they lend a smaller fraction of any new deposits, and this reduces the effect of the deposit expansion multiplier. For instance, if the reserve requirement is 10 percent, then the deposit expansion multiplier is 10. If a bank chooses to hold 20 percent of its deposits on reserve, the deposit expansion multiplier is only 5 (1/.20). If money (currency and coin) is withdrawn from the banking system and kept as cash, deposits and bank reserves are smaller, and there is less money to loan out. The removal of money reduces the deposit expansion multiplier. The money multiplier usually is relatively stable, but not always. For example during 1930-1933, in the early part of the Great Depression, the money multiplier fell sharply and it created serious problems for monetary policy (see Appendix 5). The disadvantage of money multiplier is that it could lead to financial crisis.

Central Banks and Monetary Policy


Central Bank and its Functions: Central banks are sometimes known as bankers banks because only banks (and occasionally foreign governments) can have accounts in them. Private citizens cannot go to the Central Bank and open a checking account or to borrow money. Examples of central banks are Federal Reserve System (FED) is the central bank of United States, European Central Bank (ECB) is the central bank of euro-area countries. Decisions, concerning monetary policy (for instance, choosing target(s)) in US, are the responsibility of the Federal Open Market Committee (FOMC). Although from a macroeconomic point of view the Central Banks the most important role is to control the money supply, but they are also perform several important functions for banks. These functions include clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. Beside this they are also responsible for managing exchange rates and the nations foreign exchange reserves. Clearing interbank payments works as follows. Suppose, for example in Armenia one company write a 100 AMD check drawn on Ameria Bank to pay to another company, which bank`s account is in ProCredit bank. The process, how the money from Ameria Bank (firts account) get to ProCredit Bank (second account), is implemented by Central Bank of Armenia. When Company 2 receives the check and deposits it at ProCredit Bank, the bank submits the check to the Central Bank, asking it to collect the funds from Ameria Bank. The Central Bank presents the check to America bank and then debit Ameria bank`s account for 100AMD and credit the account of ProCredit Bank. Accounts at the Central Bank stand as reserves. The two banks trade ownerships of their deposits at the Central Bank and the total volume of reserves has not changed. Central Banks are responsible for many regulations governing banking practices and standards. For example, the Federal Reserve System has the authority to control mergers among banks, and it is responsible for examining banks to ensure that they are financially stable. Also Central Banks sets reserve requirements for all financial institutions. Another important responsibility of Central Banks is to act as the lender of last resort for banking system. It provides funds to troubled banks, which are not able to find any other sources of funds.
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As it was writhen above the most important function of Central Banks is to control the money supply. For example every year during the Christmas season, the demand for currency rises because people carry more money to buy gifts. During the holiday season, the Federal Reserve System increases the supply of money. After the holiday season, the demand for money declines and public begin to deposit cash in banks. Then the banks return the cash to the Federal Reserve System. Monetary policy: Monetary policy is the government's decisions about how much money to supply. It is an important tool to affect macroeconomic behavior. Changes in the money supply will affect nominal variables such as the price level and the nominal exchange rate. Monetary policy also affects real variables such as real GDP, the real interest rate, and the unemployment rate. In almost all countries the central bank is the government institution responsible for monetary policy2.The ultimate goal of monetary policy is the economic growth with stable prices. Economic growth means greater output; stable prices mean a low, steady rate of inflation. Central banks do not control gross domestic product or the price level directly. Instead, they control the money supply, which in turn affects GDP and the level of prices. The money supply, or the growth of the money supply (monetary aggregates) or interest rates (long term and short term) are the intermediate targets, an objective that helps the Central bank. Some countries have moved away from pursuing intermediate targets like money growth rates and have instead focused on an Inflation Targeting. These countries realize that the public generally likes to see policies supporting faster economic growth, like lower interest rates, whereas fighting inflation may mean unpopular higher interest rates and slower growth. For example, in case of European Central Bank (ECB) (see Appendix 6). Inflation targeting has been adopted in several countries, including New Zealand, Canada, the U.K., Australia, Switzerland, Chile, Korea, South Africa, and Europe (by the European Central Bank). Central Bank of the Republic of Armenia (CBA) proposed the adoption of an inflation targeting strategy to achieve the legally-prescribed goal of price stability, replacing the strategy of monetary targeting, which was adopted as the method of monetary regulation since 1994. Control of money supply (tools of monetary policy): The Central Banks controls the money supply and interest rates by changing bank reserves. There are four ways that explain this; it is written for Federal Reserve System of USA 1. Required reserve rate trend down: The Fed can lower required reserve which raises the multiplier effect of high powered money (cash). The cash remains in the bank and each dollar can support more loans/demand deposit. 2. Discount interest rate decreases: The Fed can lower the discount rate and lower costs of banks holding low excess reserves which will lower the excess reserve rate. If the Fed lower the discount rate, or fixes a lower federal funds aim, this can be done if the Fed injects funds into the system which will drive down the price of those funds interest rates. To know how it could increase the level of the cash system, we can turn to open market operations. 3. Publics holding of cash changes: The Fed can raise confidence in banking system which will lower publics desire for holding cash. If you look at the high-powered money the Fed can inject into the system, a dollar in the hands of an individual is simply a dollar of
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Most industrialized countries established central banks in the nineteenth century or early twentieth century. Prior to the establishment of central banks, national treasury departments often were responsible for currency issue and other matters pertaining to the money supply.

money supply. A dollar reserves at the banks, however, can support some multiple expansion of checking accounts. 4. Open market purchases: this is the Feds primary tool of monetary policy. The Fed can buy or sell government securities (bonds). When the Fed wants to increase the money supply it will buy government securities (bonds), while if it wants to decrease the money supply it will sell government securities (bonds).Recently for example the same happened concerning current debt crisis of Greece (International Monetary Fund provided a loan to Greece of around $ 4.3 billion).The central banks of euro-area countries increased money supply by selling governmental bonds to support Greece to avoid default.

References
1. U.S. Treasury Dept., The Use and Counterfeiting of U.S. Currency Abroad, Part 3, Section 1.3, 2006. http://www.federalreserve.gov/ boarddocs/ rptcongress/counterfeit/ counterfeit2006.pdf. 2. www.federalreserve.gov /Releases/h3 3. www.federalreserve.gov/pf /pf.htm 4. www.cba.am 5. W. Boyes, M. Melvin; Macroeconomics; 2011; ISBN 13: 978-1-4390-3907-6 6. A.B. Abel, B.Bernanke; Macroeconomics; 2008; ISBN 13: 978-0-321-41554-7 7. http://fragments.awedge.net/?p=369 8. http://www.wisegeek.com/what-is-money-circulation.htm 9. http://www.investmentsandincome.com/ 10. http://www.uri.edu/ 11. P. Dalziel; Money, Credit and Price Stability; 2001; ISBN 0-415-24056-5 12. F. S. Mishkin;The Economics of Money, Banking and Financial Markets; 2004; ISBN 0321-12235-6

Appendix 1
Money in Prisoner-of-War Camp Among the Allied soldiers liberated from German prisoner- of-war (POW) camps at the end of World War II was a young man named R. A. Radford. Radford had been trained in economics, and shortly after his return home he published an article entitled "The Economic Organization of a POW Camp.'" This article, a minor classic in the economics literature, is a fascinating account of the daily lives of soldiers in several POW camps. It focuses particularly on the primitive "economies" that grew up spontaneously in the camps. The scope for economic behavior in a POW camp might seem severely limited, and to a degree that's so. There was little production of goods within the camps, although there was some trade in services, such as laundry or tailoring services and even portraiture. However, prisoners were allowed to move around freely within the compound, and they actively traded goods obtained from the Red Cross, the Germans, and other sources. Among the commodities exchanged were tinned milk, jam, butter, biscuits, and chocolate, sugar, clothing, and toilet articles. In one particular camp, which at various times had up to fifty thousand prisoners of many nationalities, active trading centers were run entirely by the prisoners. A key practical issue was how to organize the trading. At first, the camp economies used barter, but it proved to be slow and inefficient. Then the prisoners hit on the idea of using cigarettes as money. Soon prices of all goods were quoted in terms of cigarettes, and cigarettes were accepted as payment for any good or service. Even nonsmoking prisoners would happily accept cigarettes as payment, because they knew that they could easily trade the cigarettes for other things they wanted. The use of cigarette money greatly simplified the problem of making trades and helped the camp economy function much more smoothly. Why were cigarettes, rather than some other commodity, used as money by the POWs? Cigarettes satisfied a number of criteria for good money: A cigarette is a fairly standardized commodity whose value was easy for both buyers and sellers to ascertain. An individual cigarette is low enough in value that making "change" wasn't a problem. Cigarettes are portable, are easily passed from hand to hand, and don't spoil quickly. A drawback was that, as a commodity money (a form of money with an alternative use), cigarette money had a resource cost: Cigarettes that were being used as money could not simultaneously be smoked. In the same way, the traditional use of gold and silver as money was costly in that it diverted these metals from alternative uses. The use of cigarettes as money isn't restricted to POW camps. Just before the collapse of communism in Eastern Europe, cigarette money reportedly was used in Romania and other countries instead of the nearly worthless official money.
Source: ECOIlOl1lica, November 1945, pp. 189-201.

Appendix 2

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Appendix 3

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Appendix 4
Islamic Banking According to the Muslim holy book, the Koran, Islamic law prohibits interest charges on loans. Banks that operate under Islamic law still act as intermediaries between borrowers and lenders. However, they do not charge interest on loans or pay interest on deposits. Instead, they take a predetermined percentage of the borrowing firms profits until the loan is repaid, then share those profits with depositors. Since the mid-1970s, over a hundred Islamic banks have opened, most of them in Arab nations. Deposits in these banks have grown rapidly. In fact, in some banks, deposits have grown faster than good loan opportunities, forcing the banks to refuse new deposits until their loan portfolio could grow to match the available deposits. One bank in Bahrain claimed that over 60 percent of deposits during its first two years in operation were made by people who had never made a bank deposit before. In addition to profit-sharing deposits, Islamic banks typically offer checking accounts, travelers checks, and trade-related services on a fee basis. Because the growth of deposits has usually exceeded the growth of local investment opportunities, Islamic banks have been lending money to traditional banks to fund investments that satisfy the moral and commercial needs of both, such as lending to private firms. These funds cannot be used to invest in interest-bearing securities or in firms that deal in alcohol, pork, gambling, or arms. The growth of mutually profitable investment opportunities suggests that Islamic banks are meeting both the dictates of Muslim depositors and the profitability requirements of modern banking. The potential for expansion and profitability of Islamic financial services has led major banks to create units dedicated to providing Islamic banking services. In addition, there are stock mutual funds that screen firms for compliance with Islamic law before buying their stock. For instance, since most financial institutions earn and pay large amounts of interest, such firms would tend to be excluded from an Islamic mutual fund. The most popular instrument for financing Islamic investments is murabaha. This is essentially cost-plus financing, where the financial institution purchases goods or services for a client and then, over time, is repaid an amount that equals the original cost plus an additional amount of profit. Such an arrangement is even used for financing mortgages on property in the United States. A financial institution will buy a property and then charge a client rent until the rent payments equal the purchase price plus some profit. After the full payment is received, the title to the property is passed to the client.

Appendix 5
The Money Multiplier during the Great Depression The money multiplier usually is relatively stable, but not always. During 1930-1933, in the early part of the Great Depression, the money multiplier fell sharply, creating serious problems for monetary policy. The source of the instability in the money multiplier, as discussed in detail by Milton Friedman and Anna Schwartz in their Monetary History of the United States, 1867-1960, was a series of severe banking panics. A banking panic is an episode in which many banks suffer runs by depositors, with some banks being forced to close. The US panics resulted from both financial weaknesses in the banking system and the arrival of bad economic and financial news. Among
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the causes of banking panics emphasized by Friedman and Schwartz were: (1) the effects of falling agricultural prices on the economies of farm states in the autumn of 1930; (2) the failure in December 1930 of a large New York bank called the Bank of United States (a private bank, despite its name); (3) the failure in May 1931 of Austria's largest bank, which led to a European financial crisis; and (4) Great Britain's abandonment of the gold standard in September 1931. The most severe banking panic began in January 1933 and was halted only when the newly inaugurated President Franklin D. Roosevelt proclaimed a "bank holiday" that closed all the banks in March 1933. By that time more than one-third of the banks in the United States had failed or 'Princeton, been taken over by other banks. Banking reforms that were passed as part of Roosevelt's New Deal legislation restored confidence in the banking system and halted bank runs after March 1933. The banking panics affected the money multiplier in two ways. (See Fig.1) First, people became very distrustful of banks, fearing that their banks might suddenly fail and not be able to pay them the full amounts of their deposits. (These events occurred before deposits were insured by the Federal government, as they are today.) Instead of holding bank deposits, people felt safer holding currency, perhaps under the mattress or in coffee cans buried in the backyard. Conversion of deposits into currency caused the currency-deposit ratio to rise, as shown in Fig.1, with a spectacular rise in the first quarter of 1933. Second, in anticipation of possible runs, banks began to hold more reserves (including vault cash) to back their deposits, as shown in Fig.1 by the behavior of the reserve-deposit ratio. Banks hoped to convince depositors that there was enough cash in the banks' vaults to satisfy withdrawals so that the depositors would not be tempted to start a run. Increases in either the currency-deposit ratio or the reserve-deposit ratio cause the money multiplier to fall. As shown in Fig. 2(a), as a result of the banking panics, the money multiplier fell sharply, from 6.6 in March 1930 to 3.6 by the bank holiday in March 1933. Thus, even though the monetary base grew by 20% during that three-year period, the money multiplier fell by so much that the money supply fell by 35%, as shown in Fig. 2(b).

Princeton, N.J.: Princeton University Press for NBER, 1963.

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There is some controversy about whether the drop in the money supply was a primary cause of the decline in output during 1930-1933 (Friedman and Schwartz argue that it was), but there is general agreement that the drastic decline in the price level (by about one-third) in this period was the result of the plunge in the money supply.

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Appendix 6
The European Central Bank The European Central Bank (ECB) began operations on June 1, 1998, in Frankfurt, Germany, and now conducts monetary policy for the euro-area countries. The national central banks like the Bank of Italy and the German Bundesbank are still operating and perform many of the functions that they had prior to the ECB, such as bank regulation and supervision and facilitating payments systems in each nation. In some sense, they are like the regional banks of the Federal Reserve System in the United States. Monetary policy for the euro area is conducted by the ECB in Frankfurt, just as monetary policy for the United States is conducted by the Federal Reserve in Washington, D.C. Yet the national central banks of the euro area play an important role in their respective countries. The entire network of national central banks and the ECB is called the European System of Central Banks. Monetary policy for the euro area is determined by the Governing Council of the ECB. This council is composed of the heads of the national central banks of the euro-area countries plus the members of the ECB Executive Board. The board is made up of the ECB president and vice president and four others chosen by the heads of the governments of the euro-area nations. The ECB pursues a primary goal of price stability, defined as an inflation rate of less than 2 percent per year. Subject to the achievement of this primary goal, additional issues, such as economic growth, may be addressed. A benefit of a stated policy goal is that people can more easily form expectations of future ECB policy. This builds public confidence in the central bank and allows for greater stability than if the public were always trying guessing what the central bank really cares about and how policy will be changed as market conditions change.

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