Download The effects of central bank independence on the

The effects of central bank independence on the trend of
inflation and its implications on the poor in Uganda.
Abstract
This paper investigates the effect of central bank independence on the trend of
inflation in Uganda and it’s implication of the welfare of the poor especially
women. Following a empirical approach, the concept of central bank
independence and its effect on the trend of inflation was investigated. An
assessment was made on the implications of the outcome on the welfare of the
poor specifically women. The results indicated the trend of inflation turned
negative after central bank independence. This by implication had a positive
effect on the welfare of the poor, although central bank independence was
identified as one of the contributing factors in addition to the conducive
environment that had been set at the time.
Key words
Women, welfare, inflation, central bank independence
1
Ms. Elizabeth Kaase-Bwanga,
B.A (Econ and Rural Economy) M.A. (Econ) P.G.D.Ed, P .G.Comp Sc.
[email protected]
2.
Dr. Consolata Kabonesa, Department of Women and Gender Studies
[email protected], Makerere University, P. O. box 7062,
Kampala, Uganda.
1
Introduction and background
Central bank independence is the autonomy given to the central bank
through a charter which spells out a strong commitment to price stability and
freedom to pursue it. The central bank is not expected to set its own goals to
pursue, government sets the goals, but it is given adequate scope to pursue the
set goals (Fraser, 1994). In Uganda, this autonomy emanated from The 1995
Uganda Constitution and the Bank of Uganda Statute, 1993. Article 162
Section (1) and (2) of the Constitution specifies the role of Bank of Uganda with
a focus on ensuring economic stability as the primary goal.
The effectiveness of central bank independence should be discussed
within the context of the general structure of the economy. In the 1960’s,
immediately after independence, Uganda’s economy was vibrant and promising
(Lister et. al. 2006) and experienced a relatively high rate of economic growth.
The real gross domestic product (GDP) grew at an average rate of 4.8 percent,
and GDP per capita grew at about 3 percent per annum. The national savings
rate averaged about 13.4 percent of GDP and was sufficient to finance the
moderate rate of capital accumulation that amounted to less than 13 percent of
GDP. As a result the government was spending more on social services (health
education and roads), however, this situation drastically changed in 1971 when
the economy experienced domestic shocks, coupled with lack of sound macroeconomic policies. The effect of which was translated into real GDP decline to
an average of 3.8 percent per annum during 1973 – 79 (Uganda 1998). Despite
official price controls, inflation sky rocketed to over 40 percent per annum as
compared to 8.2 percent per annum during 1967 – 1970. Gross domestic
investment declined from an annual average of 12.7 percent of GDP in 1963 –
1970 to 8.6 percent during 1971 -1978, and the national savings rate declined
from 13.4 to 7.7 percent over the same period. Recurrent government revenues
declined from 14.6 percent of GDP in the 1960’s to 9.9 percent by 1978, while
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total government spending declined from marginally from 17.5 of GDP to 15.5
percent (Uganda 1998).
In the agricultural sector where most of the women (80%) are employed,
the share of agriculture to total GDP increased from 48% in 1970 to 58% in
1986 to 67% in 1990, with a down turn to 42.4 since 1997. By implication the
women’s contribution and benefits from agriculture was reducing. Data from
1992 to1999 shows that female headed households were disproportionately
(20%males and 30% women) represented among the chronically poor.
However, government revenue was spent primarily on unproductive
activities relating to internal security and defense, which absorbed over 40
percent of the recurrent and development budgets. The Table 1 gives the
available figures on the gross domestic product per capita at constant prices
and female enrolment by year. It should be noted before 1986, there were very
few private providers in education. GDP was growing, the level of enrolment
was increasing but not at parity between men and women (Uganda, 1998).
Table 1
Showing gross domestic product per capita and level of
literacy among the female population by year
Year
GDP per capita
at factor cost
1978
1979
1980
1981
1982
1983
1984
1985
1986
4,521
6,843
9.813
15,383
28,469
39,691
56,664
121,586
306,923
Source
Female enrolment in
government aided
primary schools by
%age
41.5
42.1
40.9
42.6
42.6
43.5
43.5
44.0
44.0
MFPED (Uganda), 1987; Uganda (1999)
There was substantial growth in money supply through the period 1970
– 1990’s, with considerable inflationary consequences. This was intended to
finance the government fiscal deficits. The economy also experienced a
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multitude of constraints such as foreign exchange scarcity largely due to over
reliance on coffee earnings, increased isolation of Uganda by the international
community in the mid seventies and inability to attract external aid and grants
(Uganda 1999).
The 1978-79 liberation war proved very costly to Uganda, as GDP
declined by an average rate of 7.9 percent, while gross domestic investment
dropped to as low as 6 percent of GDP. In 1980, the manufacturing subsector
was producing 60 percent below its 1971 peak level (Background to the
Budget, 1988).
Using Data for 1993/94 survey data delineates that the poverty status of
Uganda was and stood at 41.1 percent of Ugandans being relative poor, while
8.3 percent very poor and below the poverty line and the poorest of these are
women. Of the 48.7 of the population that had access to safe water, only 11
percent were within 15 minutes of a water source. The most common sources
of drinking water were springs and public wells, with grave implications for
health. Only 53 percent of deliveries were conducted by trained personnel of
which only 35.4 percent were in health facilities. Of children 12-23 months,
only 49 were immunized against the six killer diseases. Thirty nine percent of
children were stunted while 25.5% were under weight (wasted) Uganda 1999).
All these factors had negative dimension on poverty and specifically women.
In addition Uganda financial sector are characterized by thin, weak and
under-developed money and financial market, (although growing at a fast rate),
which often led to disorderly conditions in the financial markets and to large
movements in key interest rates with little impact on the availability of liquidity
and credit in the market (Katarikawe and Sebudde 2000; Opolot 2007; Bank of
Uganda 2004; 2005; and MFPED 2001; 2004; Yusuf et.al., 1999).
Against this background of pervasive distortions in the economy, a
complete breakdown in several sectors, rampant inflation and balance of
payments deficits, thin and underdeveloped financial markets and rampant
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poverty the government announced a package of measures to rehabilitate and
reconstruct the ailing economy. Central bank independence was one of them
among the measures. These measures were intended to address the traditional
sources of monetary and economic instability including monetization of the
fiscal deficit and excessive borrowing from the commercial banks.
This coincided with the wind of change at the time that emphasized
central bank independence as a necessary condition for control of inflation.
Empirical evidence from country studies including Germany, Sweden, Italy,
Denmark, New Zealand, Norway, Spain among others had confirmed the
negative relationship between central bank independence and inflation and
inflation variability and that this would come with no cost to growth. In
addition scholars including Agnor (1989; Powers (1995); Blank and Blinder
(1986) Cardoso (1992); Datt and Ravallian (1996) and Romer and Romer (1998)
show a positive relationship between low inflation and poverty rates. Above all
Uganda government was in dire need of measures to control inflation, foster
economic growth and development. Uganda was encouraged to grant the Bank
of Uganda independence. What remains to be seen is whether this autonomy
has translated into low inflation. This paper outlines the effects of central bank
independence on the trend of inflation and it’s implication on the welfare of the
poor in Uganda focusing on whether the economy was more stable after central
bank independence and the implications of this out come on the welfare of the
poor in Uganda particularly women.
Empirical Evidence
Studies investigating central bank independence for instance by Grilli et
al (1991), Cukierman et al., (1992), Alesina and Summers (1993) and Eijffinger
et. el., (1998) used legal independence as a measure of central bank
independence and reported a negative correlation between central bank
independence and average inflation. Alesina and Summers (1993) reported no
correlation between central bank independence and other real economic
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variables such as unemployment, real economic growth and real interest rates.
As a result, there is a broad consensus that central bank independence
improves the likelihood of achieving a low inflation goal at no real economic
costs. The same result is arrived at by Posen (1998) and Daunfeldt Sven-Olvo
and Xavier de Luna (2003), although using different methodologies.
Agenor (1989), Datt and Ravallion (1996) found poverty rates to be
positively related to inflation in a cross section data. Powers (1995) found that
inflation worsens the consumption based poverty measures, Blank and Blinder
(1986) found that inflation increased poverty rates but also slightly increased
the income shares of the bottom two quintiles. Cardoso (1992) argues that the
inflation tax does not affect those already under the poverty line in Latin
America because of their negligible cash holdings. However, she reported high
inflation is associated with low real wages in a panel of seven Latin American
countries.
Romer and Romer (1998) on the other hand argue that the effects of
inflation on real incomes of the poor are likely to differ between cyclical and
long-term perspectives. In the short-run an increase in inflation
(unanticipated) will be associated with a decline in unemployment and may
relatively benefit the poor. Over a long term, however, higher inflation cannot
reduce unemployment, and the effect of inflation on the poor could be reversed.
Even in a cyclical perspective, Romer and Romer, using an international panel
data, find that low inflation tends to increase income of the poor over a longterm- a result they attribute in part to the negative association between
inflation and economic growth similalry reported by Fischer and Huizinga
(1982) and Datt and Ravallion (1996).
Shiller (1996) posed a question “Why Do People Dislike Inflation”. He
conducted a questionnaire survey of 677 people in the US, Germany and
Brazil. His answer was that people perceived inflation as reducing their
standard of living. In the US sample, when asked what was their biggest
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concern about inflation, 77 percent of the sample chose to respond “inflation
hurts my real buying power”. Only 7 percent chose the traditional view of
economics that inflation causes a lot of inconveniences. When pressed further,
the majority in sample in the US, Germany and Brazil supported the view that
their wages would not rise as fast as the price level during the process of
inflation. This implied that the poor and uneducated would dislike inflation
more because they are probably less protected by asset income from changes in
their real wages. This gives support that inflation reduces the real wages of the
poor.
In the previous studies inflation was consistently more frequently cited
as a serious problem than unemployment except during recessions. Rose
(1997) found no association between the standard of living and inflation
aversion relative to unemployment aversion in a sample of polling data from excommunist countries.
Methodology
Secondary data on consumer price index (inflation) was collected from
The Uganda Bureau of Statistics (Statistical Abstracts). Consumer price index
is a measure of the cost of goods and services. The modified Laspeyres index is
used to generate the level of consumer price index.
The sample period was identified as 1980 to 2007. This sample period
was selected to provide a sample period long enough to draw inference while
taking into consideration of availability of data.
This sample was split into two sub-samples, including the period
January 1980 to December 1993 and January 1993 to December 2007
representing the pre and post central bank independence periods respectively.
Ms-excel was used to generate the line graph and trend coefficients of the
variables. This paper hypothesized that: the economy is more stable after
central bank independence than before and this would have a positive effect on
the welfare of the poor especially to women.
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The results
Trend analysis of inflation for the pre central bank independence period
The Figure 1.1
Shows the trend analysis of inflation for the period
1980 – 1993, that is, before central bank independence.
Figure 1.1 shows that the trend of inflation was negative for the period 1980 –
1993 with a slope coefficient for time factor of -5.225. This means that a unit
increase in time would reduce inflation by 5.22 percent. The
(coefficient of
determination) for this period was 0.101, meaning that time explained 10.1
percent in variation of inflation for period 1980 - 1993.
Trend analysis of inflation for the post central bank independence period
1994 - 2007.
The Figure 1.2 : Shows the trend of inflation for the post central bank
independence period, 1994 -2007.
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Figure 1.2 shows that the trend of inflation rate was negative for the period
1994 – 2007 with a slope coefficient for time factor of -0.146. This means that
a unit increase in time would reduce inflation by 0.146 percent. The
(coefficient of determination) for this period was 0.035 meaning that time
explained 3.5 percent in variation of inflation for period 1994 – 2007.
Trend analysis for inflation for the whole study period 1980 – 2007
The Figure 1.3
Shows the trend analysis for inflation over the
period 1980 – 2007.
Figure 1.3 shows that the overall trend of inflation rates was negative for
the study period 1980 – 2007 with a slope coefficient for time factor of -5.282.
This means that a unit increase in time would reduce inflation by 5.28 percent.
The
(coefficient of determination) for this period was 0.449 meaning that
time explained 44.9 percent in variation of inflation for the period 1980 – 2007.
From figures 1.1, 1.2 and 1.3, it can be observed that the trend of
inflation decelerated at slower rate with a slope coefficient of -0.416 during the
post central bank independence period compared to the slope coefficient of 5.225 before the central bank independence period. This suggests that the
trend was already negative even before central bank independence and this
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collaborated well with the overall trend analysis that was -5.282. We can
prudently argue that central bank independence helped to moderate the rate of
inflation and therefore, central bank independence could have been a
stabilizing factor with respect to inflation. This collaborated with the argument
of Daunfeldt Sven-Olvo and Xavier de Luna (2003),who argue that in most
cases low inflation was realized well before autonomy was granted.
That notwithstanding, from the trend analysis, the slope coefficients
inflation improved in performance after central bank independence. This is
collaborate by scholars including, Grilli et al (1991), Cukierman et al., (1992),
Alesina and Summers (1993) and Eijffinger et. el., (1998) that used legal
independence as a measure of central bank independence. These studies
found a negative correlation between central bank independence and average
inflation.
This result is collaborated by the facts on the ground that, Uganda has
had a track record of fiscal discipline and macroeconomic stability which has
been maintained throughout. Uganda has thus managed to maintain low
inflation. The emphasis on maintaining tight control over aggregate public
spending, with the move to a cash budget is also an indicator of the nature of
fiscal discipline and commitment to low inflation. In addition tight monetary
policy has helped restrain inflation (Uganda, 2008; Lister, 2006). Central bank
independence could have been one of the factors that could have led to such
improvement in the performance of inflation among other things. It is therefore
prudent to recommend that central bank independence should be upheld.
The effect of central bank independence on the poor especially women.
In as far as the argument goes as put by Agenor, (1189); Powers (1995);
Balnak Na Blinder (196) and Datt and Ravallian (1996) that inflation tax is
particularly unfair because the taxing mechanism being little understood, the
inflation tax can be imposed by stealth. That the rich are in a better able to
protect themselves against or benefit from, the effects of inflation, than the
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poor. In particular, that the rich and more sophisticated are likely to have
better access to financial instruments that hedge in some way against inflation,
while the (small) portfolios of the poor are likely to have a larger share of cash.
And as long as the poor depend more on the rich and on state determined
income that is not fully indexed to inflation and for the elderly poor, pensions
are not often fully indexed, inflation will directly reduce their real incomes. For
the remainder of the poor, state subsidies and transfers may also not be fully
indexed (in Uganda these are not available). Then a reduction in the inflation
rate by implication, one would conclude that there was an improvement in the
welfare of the poor and more so the women.
This is result collaborated by the Uganda’s poverty status report in June
2006 that mentions that there has been a positive trend in access to services,
greater quantity and diversity of primary education (the gender gap in primary
education has narrowed to almost 1:1 although the completion rates are still
very low for girls), health clinics and drug outlets are more common - ( 78% of
the population can access a health centre within 5km of their home) there is
greater access to agricultural extension services, improved rural roads, more
prevalent and dynamic markets and greater diversity in non-farm activities
(Uganda, 2007). It is further collaborated by Uganda (2008) that shows the
growth of real GDP as shown in the table below
Table 2
Monetary and non-monetary GDP at 2002 prices
Percentage change by fiscal year
Fiscal year
%age change in GDP
at constant prices .
2003/04
6.8
2004/05
6.3
2005/06
10.8
2006/07
7.9
2007/08
9.8
Source: Background to Budget 2008/09
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However, central bank independence was granted after several
adjustment programmes had been implemented including liberalization of the
markets, privatization and divestiture of public enterprises, financial sector
linearization, downsizing of government ministries the gender responsive
policies and improvement of the internal structures among others. It would be
unfair to suggest that the improvement of welfare of the poor as collaborated by
the trend of inflation was strictly a result of the autonomy granted to the
central bank. We can conclude that central bank independence could have by
implication, improved the well being of the poor in addition to other enabling
factors that were present.
It is therefore recommended that central bank autonomy should
continue but with caution, focusing on the other factors that move inflation
including output, interest rates, competitiveness of our good and services while
directing government expenditure to poverty reducing sector – education,
health, infrastructure and above all the land bill.
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