Running Head: CENTRAL BANK 1

Central bank

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Central Bank Independence

The legal and historical relationship between the government of a country and a central bank is
very complex and includes the role of government in many aspects of central bank such as
appointing of board of governance of central bank, governments voting power, budgetary
control, and the policy establishment of the banks charter. Majority of the discussions related to
independence of central bank in the past have concentrated on two primary dimensions of
independence. The first dimension includes those characteristics of central bank that keeps it
above the political influence in defining its objective. On the other hand, second dimension of
the independence constitutes of those aspects that allow the central bank to independently
implement and pursue its monetary policy goals (Alesina and Summers 1993).

The primary argument in favor of an independent central bank is that the power of spending
money and creating money should be separated from each other. There have been many instances
in the past where the governments around the world had abused their power to create money.
Even in third century, Roman tax authorities used to collect silver coins and melted and
combined them with other inferior metals t produce more coins that were then spent on achieving
Ceasers objectives rather than on public welfare. When the money supply increased the demand,
the economy of Roman Empire ended up in inflation. Same is happening in todays paper money
economy around the globe. Many governments reduce interest rates close to elections to boost
spending and employment level. This strategy although works in the short term, but in the long
term, it results in inflation due to incapacity of the economy to meet the higher demand
(Eijffinger and Haan 1996). However, the rise of inflation level becomes apparent after few years
and the elected government may have achieved their election objectives by then. Central banks
make the policies keeping in view the long term objectives and therefore they are not tempted by
the short term objectives like politicians.

if the decisions regarding interest rates and monetary policies are delegated to an independent
central bank with a clearly defined mandate, the public can be achieve a much better economic
outcome and stable inflation rate over the long term period. Many studies have been conducted
in the past in order to determine the validity of this argument and three major conclusions have
been reached. First, the evidences have found that there is a negative correlation between
independence of central bank and long term inflation. This means that those countries that have
an independent central bank has low inflation rate as compared to those countries in which the
central bank is in governments control. Second conclusion shows that there is a negative
correlation between independence of central bank and the budget deficit. The countries having
independent central bank has lower budget deficit, compared to countries with countries having
governments controlled central bank. Final conclusion is that there is no evidence of relationship
between independence of central bank and growth of production.in other means, the
independence of central bank does not affect the production or employment level in the country
over the long term (Walsh 2003).
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Critics argue that although there is a negative correlation between inflation rate and
independence of central bank, it does not mean that independence of central bank leads to lower
inflation. They provide the reason that those countries in which electorate is opposed to inflation
tend to keep the inflation rate down. Further, these countries are likely to have the independent
monetary authorities in order to maintain the lower inflation rate (Balls, Howat and Stansbury
2016). On the other hand, those countries where the electorates are tolerant of inflation also have
their monetary policy made by the autonomous central bank. Thus, the critics argue that inflation
is mainly determined by the preferences of the countrys inhabitants and the history of the state.
They further argue that imposition of autonomous central bank with an objective to achieve low
inflation in a country leads to failure. This criticism on the independence of central bank is not
very convincing and evidences also suggests otherwise. For instance, in the past war period;
Reserve Bank of New Zealand was regarded as one of the least independent central bank. In
1988, however, attempts were made to transform it into the highly autonomous central bank with
the objective to counter inflation. The result was that inflation rate in the country fell from
double digit to less than 2%. This shows that the independence of central bank can prove to be
highly successful.

There are three preconditions which should be fulfilled for the autonomy of central bank. First,
there should be the specific and clear legal and operational framework on the monetary policy.
The legal framework should be clearly spelled out in order to avoid the misconceptions regarding
the independence of central bank. In the framework of monetary policy, the central bank should
indicate the objective that it is trying to achieve and what operational variable and monetary
instruments it will apply to achieve the defined objectives. The reason for this is to earn the
credibility for central bank. Therefore, it is vital to draw a long term program on how the central
bank will fulfill its mission. Second condition for the independence of central bank is
transparency. Transparency could be achieved by continuously informing the government and the
general public about the monetary policy program that the central bank is following. It is highly
necessary to have regular discussion sessions between government and the central bank. Such
discussions lead to the accountability to the parliament and increase the confidence of the
government on the central bank. Furthermore, it is also important to brief the general public
regarding the monetary policy decisions and the providing them with the assessment of the
progress made in accomplishing the predefined objectives (Gobry 2012). If the central bank set
any priorities, same should be spelled out clearly to keep the public informed about the changes
and development in the monetary policy. The last and the third condition for the independence of
the central bank is the development of the efficient institutional framework under which
monetary policy and its implementation decisions could be made without any external influences
from bureaucrats. The framework should be developed to have the following independences:

1. Personnel independence: it includes the appointment and selection of the board members
and other key employees with a high professional competence and without any
compulsion from politicians.
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2. Financial independence: financial independence requires that central bank should have
complete financial resources of its own and an adequate control over its budget.
3. Instrumental independence: it includes the independence over the instruments that have
an impact on the inflation, specifically the avoidance of financing the budget deficit of
government.
4. Functional independence: it means that central bank should have a right to take decisions
on all the functional matters such as price stability and monetary policy

It can be seen that although many countries have granted their central bank the independence, the
idea of autonomous ventral banks still faces a lots of criticism due to issue of accountability. The
above discussion shows that in a true democracy, there must be certain mechanism behind the
delegation of policies to the independent financial institution in order to ensure accountability
and transparency. Therefore, instrumental independence is usually granted to the central banks
while the goals of policies are retained by the governments who also monitor the performance of
the central banks in achieving its goals.
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References
Alesina, A, and L. Summers. "Central Bank Independence and Macroeconomic Performance."
Journal of Money, Credit, and Banking, 1993: 157-162.

Balls, Ed, James Howat, and Anna Stansbury. Central Bank Independence Revisited:After the
financial crisis, what should a model central bank look like? Harvard: Harvard Kennedy
School, 2016.

Eijffinger, S, and J. de Haan. The Political Economy of Central-Bank Independence. Princeton:

Princeton University, 1996.

Gobry, Pascal-Emmanuel. TIME TO ADMIT IT: Independent Central Banking Has Been A
Failure. May 24, 2012. http://www.businessinsider.com/why-are-central-banks-
independent-2012-5 (accessed April 17, 2017).

Walsh, C. E. Monetary Theory and Policy. MA: MIT Press, 2003.