Surname 1Name:University:Course:Tutor:Date: Central Bank Independence Introduction Macroeconomics is a crucial factor in every country’s economy since it monitors theperformance, structure, decision making and behavior of the economy. To be able to understandthe function of the economy then economists must study elements of economics such as; priceindices, GDP, and unemployment rates; this will be important in elaborating national income,savings, consumption, investment, international trade, unemployment, output, internationalfinance, and more importantly inflation (Wang, p.2). Most of these functions are entrusted to thecentral bank which seeks autonomy so as to effectively work everything out. The central bank is mandated with implementing monetary policies, checking interestrates, controlling the supply of money, banks for the government and acts as the lender of lastresort, administer foreign exchange, gold reserves, and the stock register, it supervises andregulates the banking sector and establishes the interest rates so as to manage exchange rates andinflation (Eijffinger, & Haan, p.3). Without independence these tasks will be manipulated to suitindividual government or political needs hence plunge the country into financial catastrophe. As cited by Alesina, & Summers, p.151 in the article “Central Bank Independence andMacroeconomic Performance: Some Comparative Evidence” Central Bank’s independence isdifferent based on each countries policies; they also indicate that the more independent Central
Surname 2banks are the lower the levels of inflation. Central bank is also associated with such economicindictors such as growth, interest rates and unemployment while it generally upholds pricestability. The paper focuses on microeconomics especially on central bank independence and itadvantages and disadvantages. It also consist of a review and critique of 5 articles related to thetopic areas of macroeconomics and chosen from the Federal Reserve publications of the 12different Federal Reserve District Banks over the period 2004-2010. It specifically tackles thetopic on inflation and its relation to central bank independence. The two article used in the paperthat are not in the 2004 – 2010 year bracket have been used to give a clear understanding oninflation and central bank independence. The two articles are Eijffinger, & Haan, in the workingpaper ‘The Political Economy of Central Bank Independence’ and Alesina, & Summers, in thearticle “Central Bank Independence and Macroeconomic Performance: Some ComparativeEvidence”. The independence of central bank Independence indicates that central bank is free from any political, legislative, orexecutive control of the government. It also indicates that it is free from private or groups controlin that it never serves the interest of few individuals but rather the whole nation. It shouldtherefore be free to undertake its mandate without external pressure that may stall economicprogress and monitoring (Alesina, & Summers, p.152). The most sensitive role of central bank of producing currency or money for a countryemphasizes the very fact that it should be autonomous in that it should not be controlled by anyelected persons rather than professionals with the interest of the country at heart. This will avoidmanipulation of the central bank operations for short term political ambitions. Accountability is
Surname 3stressed in all its operations so that its operations of monetary policy and price stability objectivecan be attained without prejudice. When the power to create money is merged with the power to spend there is possiblemisuse and abuse of the power to create money. This can be seen where governments control thecentral bank where more money is printed during election periods which boosts employment andspending in the short term but the nation crunch into high inflation afterwards in the long term(Alesina, & Summers, p.152). With the separation of the power to spend and power to createmoney this is avoided. This means that no political or selfish interest will be served. Central bank base its policies on the long term and this helps in attaining future growthsince no policy is compromised to suit political interests. The professionals operate on the longterm and thus decisions on interest rates and money matters are made appropriately on themandate that will benefit the society Eijffinger, & Haan, p.11. Central bank independence hasbeen associated with low inflation rates and lower long term budget deficits. Despite the benefits of autonomy of central bank it can be negative in that it forms anoverall economic policy and thus no clear separation of other policies such as the fiscal,monetary, labor and trade. This may lead to conflict of objectives which may lead to harming theeconomy (Alesina, & Summers, p.154). Democracy has also made independence of central bankcompromised since it dictates that there is need for accountability to elected leaders and hence inone way or the other central bank must be controlled by the legislature. For central bank to remain independent there must be a comprehensive legal andoperational structure that outlines the monetary structure that should be followed; this should bedevoid of any misconceptions or conflicts to ensure a smooth running (Eijffinger, & Haan, p.13).Transparency is also required from the bank. Continuous updates to government and public is
Surname 4necessary that will be proof of accountability in all departments. The public will also be able toassess the progress and helps in gaining confidence in the bank and the monetary policy. An effective institutional framework that ensures decisions on the monetary policy aremade and implemented effectively and without any interference from political entities. Thedecisions to be made and implemented include; functional independence (right to make decisionson monetary policy and price stability), personnel independence (including free selection of theboard of trustees), instrumental independence (control of all elements of inflation such aspreventing financing of government insufficiency) and financial independence (that ensurescentral bank has adequate finances for it to control its own full budget) (Alesina, & Summers,p.155). Inflation Targeting and Central Bank Research has indicated that where there is an independent central bank there are lowerrates of inflation. According to Eijffinger, & Haan, p.12 in the working paper ‘The PoliticalEconomy of Central Bank Independence’ there are three explanations that explain thephenomenon of central bank independence being associated with low inflation rates theseinclude; public choice argument, the study of Sargent and Wallace, and the time inconsistencecrisis of monetary policy. The public choice perspective indicates that authorities dealing with monetary policiesare exposed to pressures from political spheres so as to fulfill government objectives. Due tomonetary constraints makes the government adjust the budget. This is through reduced taxincome due to temporary economic slowdown lowers the seigniorage and public debt burden inthe short run. This makes the government prefer the easiest way to obtain finance which is
Surname 5through central bank (Eijffinger, & Haan, p.15). This will not be the case if central bank isindependent. Sargent, & Wallace indicated that fiscal and monetary authorities must be distinguished,i.e. money becomes endogenous when the six of the budget cannot be influenced by monetaryauthorities. If the public taxes also does not then finance the debt the budget is constrained thuscentral bank must create money to clear the deficit if they are government aligned (Eijffinger, &Haan, p.15). Thus independence means they will not finance such budgets without prior plans ofits effects. Time inconsistency also account for inflation is time inconsistency, where plans made forthe future become unviable with the start of the period budgeted for. The government and thepublic must be able to cover the lost time thus the government applies incentives thus remains ata deficit (Lacker, & Weinberg, p.205). Inflation targeting is one of the strategies of monetary policy that involves five aspects,firstly is the medium term numerical inflation targets announced by the public; secondly is themonetary policy primary goal set as a commitment to price stability while other goals aresubordinate; third is the use of many variables to decide the setting of the instruments of thepolicy through an informative strategy; fourth is transparency guarantees that is cultivatedthrough continuous communication with the public on the monetary policy; and fifth is theaccountability in attaining the objectives set on inflation for the central bank (Eijffinger, & Haan,p.15). This ensures long term control of inflation where the nation continues to reap the benefitsas time passes. Cohen‐Cole, & Cosmaciuc, p.1 in the working paper ‘In Noise We Trust? OptimalMonetary Policy with Random Targets’ addresses the issue of monetary policy that the central
Surname 6bank uses to achieve randomized inflation targets rather than fixed targets that have a fasterpotential of convergence. For transition environments randomized are observed to achieve fasterconvergence. Cohen‐Cole, & Cosmaciuc, uses two ideologies to explain the monetary policywhere the first is the power of central bank to influence in the short run the real economy.Secondly is the apposite monetary policy mechanism or framework to apply in the transitionenvironments. Inflation targeting systems generally contribute to a decline in rapid inflation inconditions of hyper inflation. This is contributed by bolder objectives of inflation targets andmore importantly presence of skillful bankers who implement the objectives. This can only beachieved through independence of the central bank where there is no interference with theoperations and management (Hornstein, p.317). The autonomy will be effective since short termgoals of inflation targeting set by politicians for personal gain will be eliminated thus controllinginflation and other aspects of the macroeconomics. The bankers must also be credible enough to the public such that pronouncement of lowinflation policy will be taken into consideration. In the event the bankers are not credible theirpronouncements will be countered by the public that may negatively affect the monetary policy(Lacker, & Weinberg, p.209). In cases where there are transitional expectations where regimesare changing guards there are always high expectations from the population that must beaddressed by the bankers without prejudice. For incoming governments setting inflation rates at randomized figures makes themcredible; this is so because the inflation targets from the previous regime may be lower and thussetting higher levels of inflation will make then incredible (Hornstein, p.317). Therefore, thegovernment results to set an inflation rate that is random rather than fixed so that to avoid any
Surname 7commitments, the public may take it that the figures that are randomized will be lower than theprevious regimes thus the previous regime gains population confidence. When such regimes areallowed to control central bank this will result to short term political ambitions that may plungethe nation to financial crisis. In Cohen‐Cole, & Cosmaciuc, p.3 “Monetary policy randomization has potentialapplication in at least three cases. Two of these cover the “high” inflation situation,hyperinflation and persistent inflation. In situations of hyperinflation, a faster convergence rate isclearly desirable, especially since most “losses” occur in the short run.” The objective of central bank is to stabilize domestic inflation and also the output gapgiven a flexible inflation target regime this means that they must be able to adjust domesticinterest rates that will not be affected by foreign interest rates. This is the major reason thatcentral bank needs monetary autonomy (Mukherjee, p.5). The macroeconomics trireme states that at most two of the three conditions stated belowcan be chosen in the inflation of small open economies; these are, “Autonomous monetary policyin the sense of different domestic and foreign interest rates, a fixed exchange rate and/or Perfectcapital mobility” (Mukherjee, p.5). The autonomy of the monetary policy is where the centralbank is independent to carry out the required operations. Inflation targeting is applied by central bank to give the public an estimate of the inflationrates targeted by the bank. These targets are then achieved through changes in interest rates andother monetary options (Williams, p.4). Interest rates and inflation tend to be inverselyproportional hence in the event that inflation is higher than expected lowering the raising theinterest rates will reverse the inflation. When inflation is lower than targeted lowering theinterest rates is the expected move so that inflation can rise.
Surname 8 This policy can be employed by central to control aspects of macroeconomics. Theknowledge of inflation targeting makes investors have an idea of what the central bank targets ofthe inflation rates are thus they can easily the approximate changes that interest rates will besubject to thus plan appropriately on their investments (Wang, p.5). The investors are alsoconfident about their investments in view of the fact that they can plan so that the inflation ratesdo not impact negatively on their businesses. This has positive effects in that investor confidencetranslates to a stable economy of the nation. For states that practice inflation targeting most ofthem are successful given that the markets are predictable and accountable which attractnumerous investors. The Federal Reserve’s policy has been involved together with the FederalOpen Market Committee (FOMC) in the targeting of inflation which is not an exact explicitfigure. The inflation targeting framework should not be just based on announcing figures themanagement of central bank should ensure that the announcement to the public gives themedium and long term objectives for inflation which may be given as a point or varied range. Itmust also be institutionally committed to stabilizing of price as a primary objective supported byother goals. Giving price stability a priority gives credibility to central bank so as to attain theinflation targets (Mukherjee, p.8). In this case exchange rates ought not to be targeted. Central bank should also ensure that there is monetary transparency; this ensures thatthere is effective communication about the goals of the policy to the markets and public.Accountability is also essential to achieve the inflation targets where all rationale and decisionsmade should be accounted for. The public must be kept in the know so as to achieve the requiredcredibility, as Cohen‐Cole, & Cosmaciuc, p.3 quotes ‘The public does not have knowledge of thegovernment’s methods or desires, but is able to learn from the government’s prior actions. This
Surname 9is an abstraction that seems appropriate in a situation of low government credibility. Essentiallyit assumes zero credibility – any announcement is equivalent to none at all. The public derives allnew information from the actions themselves’. To achieve inflation targeting the governmentshould not have or should have minimum burdens of financial deficits in its budget and mostimportant is that central bank should remain autonomous or have a strong degree of autonomy. The idea of inflation targeting generally occurs and is formulated under perfectknowledge however in the actual business environment there is imperfect knowledge. Williams,p.2 in his article ‘Inflation Targeting under Imperfect Knowledge’ identifies factors that impacton inflation targeting in circumstances where there is imperfect knowledge. Policy makers are not sure on the evolution of natural rates; for example natural rates ofinterests and unemployment are never predictable hence operation in imperfect knowledge formost economies (Williams, p.6). This gives a challenge to the small economies that base oninflation targeting since it may result to errors thus hinder stability. The economic structure isalso uncertain and thus policy makers rely on estimates. Macroeconomics and inflation targeting Many central banks target on lowering inflation and its volatility as the primaryobjectives while other objectives of output are sidelined, but most of those who use inflationtargets have reduced inflation. Growth of the economy is also pursued as a secondary objective.The true costs of inflation therefore are detected on the output growth, employment, distributionof income and poverty (Sierra, & Yeager, p.47). Though many countries target inflation it hasremained low even in those countries that use other monetary policies other than inflationtargeting this does not mean the inflation targeting is not effective but it sets the records straightthat inflation targeting can be affected by other secondary factors beyond central banks.
Surname 10 The credibility of central bank is also at stake if the targets are not achieved this meansthat effective policies must be ensured by the experts to make the sacrifice ratio to count. Factorsthat might affect inflation such as exchange rates must be monitored effectively so as not tonegatively affect the inflation targets (Sierra, & Yeager, p.49). Proper coordination betweeneconomic policies and the monetary policy would ensure that all targets of growth are met sincelower inflation rates would set a platform for economic growth and investment. Inflation which is measured as the consumer price index i.e. the price change forconsumer products normally assumes that there is money supply in the economy. Oil as a majorcommodity has increased in price at different times resulting to increase in prices of otherconsumer products the basis of inflation to measure growth would be misleading since they aresubject to numerous fluctuations (Sierra, & Yeager, p.53). However a stable financialenvironment there is an imperative precondition that fosters economic growth and development. Conclusion Inflation targeting mainly aims at price stability and when this is achieved there isprotection of currency from fluctuations which in turn contribute to sustainable growth. Inflationhas implications on the distribution of income and wealth this in view of the fact that the wealthyhave the means to buy non monetary assets thus protect themselves from inflation. Whenunexpected inflation occurs those who have saved and those earning fixed incomes are affectedmost while borrowers benefit. High inflation drives the prices of consumer able products highand thus the poor are affected since they cannot be able to afford. Inflation also affects the systems of tax; this is because most tax systems never accountfor inflation. When income rises with inflation it will lead to higher taxation thus reducesmonthly incomes for earners. Unmonitored inflation levels in any country will impact on the
Surname 11decision making processes. It will be difficult to make decisions since inflation levels and pricestability is uncertain. This translates to poor development and growth since price systems areunpredictable and thus less efficient. With a stable inflation rate many investors are confidentand this leads to numerous investments that lead to growth and development. Many analysts may argue that inflation targeting may have its negative impacts of highunemployment in the short run but benefits in the long run will supersede those achieved byother policies. Inflation targeting does not only target stable prices but also contribute to thegrowth and development of all the macroeconomics of a region but this is achieved with anindependent central bank.
Surname 12 Work Cited:Alesina, Alberto & Summers, Lawrence H. “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence”. Journal of Money, Credit and Banking, Vol. 25, (2). (May, 1993): p. 151-162. <http://econ.ucdenver.edu/smith/econ4110/Alesina %20Summers%20-%20Central%20Bank%20Independence%20and%20Macro %20Performance.pdf>Cohen‐Cole, Ethan & Cosmaciuc, Bogdan. In Noise We Trust? Optimal Monetary Policy with Random Targets. Working Paper No. 06‐14 Federal Reserve Bank of Boston. (October 2006). http://www.bos.frb.org/economic/wp/wp2006/wp0614.pdfEijffinger, Sylvester C.W. & Haan, Jakob D ‘The Political Economy of Central Bank Independence. Special Papers in International Economics No.19. (May 1996). <http://www.princeton.edu/~ies/IES_Special_Papers/SP19.pdf>Epstein, Gerald & Yeldan, Erinc A. Inflation Targeting, Employment Creation and Economic Development. G-24 Policy Brief No.14. (2009) <http://www.g24.org/pbno14.pdf>Hornstein, Andreas. Evolving Inflation Dynamics and the New Keynesian Phillips Curve. Economic Quarterly. Vol.93, (4) (2007): p. 317–339. <http://www.richmondfed.org/publications/research/economic_quarterly/2007/fall/pdf/ho rnstein.pdf>Lacker, Jeffrey M. & Weinberg, John A. Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve. Economic Quarterly. Vol.93, (3) (2007): p. 201–227. < http://www.richmondfed.org/publications/research/economic_quarterly/2007/summer/pdf /lacker_weinberg.pdf>
Surname 13Mukherjee, Sanchita.The Effects of Capital Market Openness on Exchange Rate Pass-through and Welfare in an Inflation-Targeting Small Open Economy. Working paper 10-18 of the Federal Reserve Bank of Cleveland. October 2010 <http://www.clevelandfed.org/research/Workpaper/2010/wp1018.pdf>Sierra, Gregory E. & Yeager, Timothy J. What Does the Federal Reserve’s Economic Value Model Tell Us about Interest Rate Risk at U.S. Community Banks? Federal Reserve Bank of St. Louis Review, Vol.86(6), (November/December 2004): p. 45-60..<http://research.stlouisfed.org/publications/review/04/11/SierraYeager.pdf >Wang, Jian. Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy Research Department. Working Paper 0701 Federal Reserve Bank of Dallas. (April, 2008). < http://dallasfed.org/research/papers/2007/wp0701.pdf>Williams, John C. Inflation Targeting under Imperfect Knowledge. FRBSF Economic Review. (2007). < http://www.frbsf.org/publications/economics/review/2007/er1-23.pdf>