Download Talk: Central bank independence

Origin of Idea on Central Bank Independence
Dynamic time inconsistency theories (Kydland and Prescott
(1977), Barro and Gordon (1983), Rogoff (1985), Miller
and Salmon (1985)) emphasise that policy rules are better
than the discretion in controlling inflation.
These views are consistent with Friedman’s (1968)
argument that monetary policy can be used in attaining the
stability of price level rather than real variables such as
unemployment, output or higher growth rate of output or
the real interest rate in an economy.
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Central Bank Independence in Practice
Following good experience of Germany and Switzerland
many countries, including New Zealand, Chile, Mexico,
Spain, France and UK adopted legislation to make their
own central banks more autonomous from the government
(Cukierman (1994), Goodhart (1994)).
The European Central Bank and the Federal Reserve
System in the US have enough independence in conduct of
monetary policy in their respective jurisdiction.
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Spirit of Central Bank Independence
If higher rate of inflation does not disappear in the long run it is not
because of lack of knowledge on how to control it but because
policy makers do not want to control it.
Stability prices create an economic environment where investment
and trade can prosper.
The Central Bank Independence (CBI) legislation directs a CB to
achieve price stability even by disregarding other objectives such
as high employment, growth, lower interest rate or financing the
government budget deficit.
More independent central banks have been able to control inflation
as reported in Alesina and Summers (1993).
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Economic and Political Independence of a CB
Economic independence refers to the central banks’ ability
to use monetary instruments without any restriction. It is
essentially measured by how easy is it for the government
to access the central bank to finance its own deficit.
Political independence depends on institutional relation
between the central bank and the executive – it involves
procedures to nominate and dismiss the head of the central
bank, role of government officials in the governing board
of the central bank. Tenure of the central banker is more
secured if for a more independent central bank.
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Theoretical Case for Central Bank Independence
Theoretical case is that most of the policy makers have inflationary
bias. Monetary policy enables them to reduce the real value of the
outstanding debt, to finance the budget deficit, to create more
employment temporarily by reducing the interest rate by increasing
the supply of high powered money.
This temptation to inflation bias among the policy makers can be
avoided by pre-committing to a low inflation policy that was set
before the negotiation for the wage-contracts.
Price stability, under such policy rule, is achieved when money
supply grows at the rate of the growth rate of output in the
economy.
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Analysis of inflationary Bias
(1) preferences regarding inflation and output
(2) instrument potency: money supply rule
Constant growth rate of money supply
Taylor rule
McCallum Rule
(3)
Macroeconomic constraints such as the Aggregate
Supply Curve.
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Inflation Biases of a Government and a Central Bank
Figure 1
Preference of government and a conservative central bank regarding inflation and output
AS
Preference of Government (GP)
Inflation
A
AS1
B
O
Preference of a CB (CP)
Yn
Output
G
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Response of Conservative and Liberal Central
Banks to a Supply Shock
Figure 2
Supply Shock AS2
Inflation
AS1
c
b
AD2
a
d
e
AD
AD1
Y*
Response of conservative and liberal central bank to an adverse supply shock
a = original equilibrium b = equilibrium after supply shock c= response if the central bank only cares
about output d= response if the central bank only cares about low inflation
The original equilibrium is at point a where short run AD and AS coincide with the long
run supply curve. A supply shock brings economy to point b. A conservative central bank
reduces money supply to accommodate to the supply shock and brings economy to point
d even if it creates unemployment and recession. Economy eventually returns to point e
along AD1. In contrast, A liberal central bank would pursue an expansionary policy
inflating the economy to point c. However, increased
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Inflationary Bias Model-Loss Functions of a
Government and a CB and Supply Constraint
Governments objective function:
2
Min G 1 2 b 

*
L   t   yt  yt 
2
2

t
(1)
Central banks’ objective function:
2
Min CB 1  2 b 

*
L 
 t   yt  yt 
2
2

t
(2)
Aggregate supply Constraints:
yt   t   te   ut
(3)
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Inflation Bias of the Government
2


b
1
LG   t2    t  te   ut  yt* 
2
2

LG    b   e   u  y*   0
t   t t  t t 
 t
b y*  b u
 t 
1 b t 1 b t
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Inflation Bias of the Central Bank
2


1


b
CB
2
e
*
L 
 t    t  t   ut  yt 
2
2

LCB  1    b   e   u  y* 
t   t t  t t 
 t
 t 
b
yt*  b ut
1   b
1   b
Here  is the inflation aversion factor. Since  0 the
central bank would choose lower rate of inflation than
the government.
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Inflation Bias When the Central Bank is under the
Spell or when it is Completely Independent
2
2
1  
1
b
b
2
e
*
2
e
*




Mt  
 t    t   t  ut  yt    1     t    t   t  ut  yt 
2
 
2

 2
2







1    1   2  b  b1       e  u  y*  2 
t
t
t t 
2
2  t 2
2
Mt

 

Mt

1  
 2   b  
 
  t
 t
2
2 






 te   ut


2 

 yt*  
 

M t
 

e
*


 1   t  b  t  t   ut  yt   0
 t
 

t  b
yt*  b ut
1   b
1   b
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Response of a “Hard-nosed” or “Wet-nosed”
Central Banks to Supply Shocks
Negative and Positive Shocks and Response of Conservative and Liberal Central Banks
LAS-
Inflation,
SAS-
LAS+
LAS
a
SAS+
SAS
SASC_
c
c
y 1
SASC+
SASC
b
e
d
y
f
y 1
A “Hard-nosed” central banks permits no inflation, “wet nosed” would accept no
decrease in inflation a the cost of output.
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Importance of Credibility and Flexibility of
Wage Rate in Inflation Reduction
Impact of Flexibility in inflation reduction
AD
S

A
S1
Impact of credibility in inflation reduction
S
S1
AD
S2
A

S2
AD1
AD1 B
B
S3
C
C
D
D
O
Y
S2 =inflexible wage rates
O
Y
S1-S3 (A-D) with credibility
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Lessons for Price Stability From Analysis of
the Central Bank Independence
1. Bind the central bank with a zero inflation rate target.
2. Appoint the most conservative central banker.
3. Make the central bank as independent as possible from
the government.
4. Peg the exchange rate to the currency of a country with
one or more of the above characteristics.
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References
Alberto Alesina, Lawrence H. Summers Central Bank Independence and Macroeconomic
Performance: Some Comparative Evidence Journal of Money, Credit and Banking, Vol.
25, No. 2. (May, 1993), pp. 151-162.
Alex Cukierman (1994) Policy Forum: The Banking System and Monetary Control
Central Bank Independence and Monetary Control The Economic Journal, Vol.
104, No. 427. November, pp. 1437-1448
Bank of England (www.bankofengland.co.uk) The Transmission Mechanism of Monetary Policy.
Barro R.J. and D. B. Gordon (1983) Rules, Discretion and Reputation in a Model of Monetary Policy,
Journal of Monetary Economics, 12: 101-121, North-Holland.
Eijffinger SCW and J.D. Haan (2000) European Monetary and Fiscal Policy, Oxford
University Press.
Gartner Manfred, Macroeconomics, Prentice Hall, 2003, chapter 13.
Goodhard Charles AE (1994) Game Theory for Central Bankers: A Report to the
Governor of the Bank of England, Journal of Economic Literature, March pp.101-115.
Goodhart C.E.A. (1994) What should central banks do? What should be their macroeconomic objective and
operations?, Economic Journal, 104, November, 1424-1436.
Gregorio Jose De (1995) Policy Accommodation and Gradual Stabilisations, Journal of
Money, Credit and Banking, Vol. 27, No. 3. August, pp. 727-741.
HM Treasury (2002) “UK Model of Central Bank Independence: An Assessment” in Reforming Britain’s
Economic and Financial Policy, Palgrave pp. 85-109.
http://www.fsa.gov.uk/
Kydland F.E and E.C. Prescott (1977) Rules rather than discretion: the Inconsistency of Optimal Plans,
Journal of Political Economy, 85:3: 473-491.
Marcus Miller, Mark Salmon (1985) Dynamic Games and the Time Inconsistency of Optimal Policy in
Open Economies The Economic Journal, Vol. 95, Supplement: Conference Papers. pp. 124-137.
Taylor J (1993) Discretion versus policy rules in practice, Carnegie Rochester Conference
Series on Public Policy 29 Amsterdam.
John B. Taylor (1995) Symposia: The Monetary Transmission Mechanism
the Monetary Transmission Mechanism: An Empirical Framework The Journal of
Economic Perspectives, Vol. 9, No. 4. Autumn, pp. 11-26.
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