Central Banks With Different Independence Degrees Finance Essay
The latest decades have witness that a great many countries have executed reforms to give their monetary authorities larger independence to stabilize the price level. Many significant researches have studied central bank independence and its relationship between inflation and real economic process. Almost early research maintained that central bank independence was negatively related to average inflation rate. However, the argument on whether central bank autonomy will cause better inflation performance is still controversial.
The following paper tends to examine that whether greater central bank independence is able to result in better inflation performance upon the theorical front. More particularlyÂ§, this paper will describe different independence degrees, methods to measure them, and why the central bank independence is important for price stability based on the systematize of existing reaserch and literature.
According to Friedman(1962), central bank independence refers to the level that a central bank can be independent from its government which is restricted by law. That is to say, the freedom of monetary policy-makers or governmental impact on the enforcement of the policy. Central bank independenceï¼ˆCBIï¼‰is quite different across countries. Some can be run freely by the governor, while others have to be compliant to the government. However, there is a trend of central banks increasing their independence.
The empirical findings led to a important body of the essay addressing the following questions:Does it necessary to reform the central bank legislation for granting central bank autonomy? What is the impact will a independent central bank on the economy activities? How and why to measure central bank independence?There will be five parts in this thesis. The first part is introduction. The second part states the importance of central bank independence on price stability. The third section will introduce some typical Central Banks with different levels of independence, comparing the inflation rate in their countries and analyzing the correlation between Central Bank Independence (CBI) and inflation. To be specific, to examine whether higher central bank autonomy will contribute to better inflation performance. Then in the fourth part, I will try to find out how the central bank independence can be measured by introducing some indices of CBI. The last section states the conclusion, as well as discussion about some possible future work.
2.The importance of central bank independence
2.1.The meaning of central bank independence
The connection between a government and its central bank can be quite complicated, regarding many different facets. Such as, the voting power of the central bank governing board, the degree to which the central bank must lend to the government, and the policy goals set in central bank's charter.
The central bank independence indicates the self-rule of central bank can programme and accomplishÂ§ monetary policy to touch the goal of price stablity, but not the unlimitedÂ§ independence.
The areas where the impact of government should be omitted have been proposeÂ§d by
Hasse(1990).They are policy independence, financial independence and personnel independence. The more common statement is goal independence and instrument independence from Debelle and Fischer (1994).
Goal independence is a central bank's ability to decide the targets of policy without the direct impact of the authority. For example, the Fed's goals are described vaguely, so it has a high degree of goal independence. The inflation goal is set by the government in the UK, thus the Bank of England is short for goal independence. Price stability is the goal of the European Central Bank, but it can decide how to translate this goal concerning the definition of price stability.
Instrument independence pertains only towards a central bank's ability to adjust its policy tools freely. The Fed and the ECB have absolute instrument independence. And given its inflation mandate set by the government, the Bank of England can establish its instruments without government's influence.
2.2 Overview of Central Banks with Different Independence Degree
The debate for an independent central bank is that it helps monetary policy to get formulated along with a long-term aim of pursuing stable prices and avoids monetary policy from being exercised for short-term reason. The typical independent central banks are the Federal Reserve , the German Bundesbank, the ECB and the Reserve Bank of New Zealand.
Conversely, proponents for subservient central banks may believe that monetary policy ought to be subject finally to democratic control. The Bank of England is a example of this type. The governor from the Bank of England is of critical importance for his professional knowledgeÂ§ in the economic field, and the top quality of information that he received via other specialized staff which will really be the crucialÂ§ assistance to policy-makers.
Some economists see Japan as an exception of the general rules for the negative relationship between CBI and inflation. It is generally accepted that the Bank of Japan closed related to its central government. To put it differently, the Ministry of Finance in Japan has the liability to enforceÂ§ monetary policy. However, Japan's inflation record turns to be quite excellent.
Barro-Gorgon model(1993) illustrate the equilibrium inflation rate under a random policy which equals to Î±Îº/Î².More specifically, Î± represents the influence of real output on inflation rate. Walsh(1995) had proved that Japan was one of the countries that had the minimum Î±. Îºmeans the unemployment rate . Japan's low unemployment rate may be a key root bringing about its low inflation. As a final point,Î²is defined as the parameter weight in policy maker's preference function, which has only been thought about in our analysis.
According to the statement above, there are also some other factors playing important parts in promoting low inflation rate. Therefore, Japan's low inflation is not surprising.
3.Relationship Between CBI and Inflation
3.1. Description of the Relationship
As we know, the less independent a central bank is, the more effect the government has on the execution of monetary policy. What should be taken into account is that a central bank is impossibly in absolute independence or subordinate position from the political authorities. That is to say, there is no complete bound between independence and subservience. When it refers to the central bank independence, a criteria called CBI index has been establishÂ§ed to measure the degree.The measurement has been developed by Bade and Parkin , Alsina(1988), Grilli, Masciandaro and Taballini , Cukierman , Eijffinger and Schaling (1992,1993) and so on, measuring the degree of independence of central banks between different countries. To be specific, in this index, "0" represents the level which is the most influenced by its government, and "1" stands for the one which is the most independent. All the indeice put diversified weight upon different criteria of central bank independence.
Empirical and theoretical results have found an contraryÂ§ relationship between CBI and the inflation level. Robert J. Franzese, Jr.1(1997), Bade and Parkin , Alesina , Cukierman et al.  and Siklos  have identified a crucial connection between central bank independence and inflation level. Thus the empiricist have supposed that there is a fixed negative influence on inflation rate, ceteris paribus, on every degree of CBI. In other words, the effect of CBI associated with inflation has been assumed constant.
Figure 1: A Typical Relation Between Inflation and CBI
Source: Robert J. Franzese, Jr.1 (1997) Independent Central Banks, Politically Responsive Governments, and Inflation Independent Central Banks, Politically Responsive Governments, and Inflation
The figure above compares postwar-average inflation rate in some countries using an central bank independent index. Obviously, the relationship between CBI and inflation rate can be described as follows: every 0.1 rise in CBI turns to result in a fixed decrease(0.5) in inflation rate, and vice versa. The negative connection is still satisfied though only a few of the dots are just on the line, because the points that are scattered on the two sides of the line disproportionally do not have absolute dispersion.
3.2. Why does the relationship exist?
Perhaps emphasizing on either short-term or long-term interest is the most important difference between the decision of the Central Bank and the Government. An elected government that concentrates on its immediate popularity may make a concession to cut down interest rates , which may encourage spending and employment for the forseeable future, and apparent prosperityÂ§ will come outÂ§ for a short period. But it will not be long-drawn,and will bring about higher inflation for a long period of time, which will finallyÂ§ cause a more serious economic problem. That is why a dependent Central Bank is in face of higher level of inflation.
From another point of view , the more independent a Central bank is, the better it can perform due to its resistance of the pressure to make decisions which are conflictable with its long-term goals. Charles T. Carlstrom and Timothy S. Fuerst (2006) presented the argument that Central banks independence was obtained primarily from institutional reforms such as long-term appointments for the governors of central banks. The common element of inflation target and central bank independence is restricted by the fiscal authorities. Therefore, lower inflation goal is more likely to be fulfilled by these institutions.
Due to the fact that in practice some central banks are more independent while others are subservient to its government, it is worth making an assessment of CBI. This section describes the four indexes of central bank independence brought forward by some previous papers.
4.1The first index was structured by Bade and Parkin(1977) which was on the basis of Political Business Cycle Theory. It examined the following questions.
The first one is what the initial target of central bank is. The answer is that price stability is the only economic objective for central bank in terms of its level of independence. The second one comes to central bank board, which reveals whether the central bank can freely perform the monetary policy. At the meantime, it can also check forÂ§ whether the politician is at the deficiency of esponsibility on central bank's board. The last one is the appointment of the chief stuff in central bank. According to different condition, the above three areas are divided into 8 parts. The overall scores is range from 1 (the most dependent) and to 4 (the most independent). The bigger the score is, the more independent the central bank will be and vice versa.
4.2The other measurement was introduced by Grilli, Masciandaro & Tabellini(1991), which has been widely known as GMT index now. They have divided central bank independence into two parts: economic independence and political independence.This index is the indicator for both of them, which are differentiateÂ§d for the first time. The former depends on whether the central bank is able to control the amount of credit which should be lent to the government, and the degree of freedom to decide the interest rate charged on the credit. What is more, it also hinges on the control power of the central bank about the tools of monetary policy. A central bank is regarded as an independent one when it is confronted with greater restrictions to finance the fiscal deficit and less liabilities on banking supervision. GMT argues that the latter component is determined by severalÂ§ elements, such as the office term of central bank officials, the process to appoint and removing central bank governors, and whether the responsibility of the central bank is definitely included in the central bank charter. That is to say, this part mirrors the level to which central bank can focus on its target on persuing price stability without conflict with the government. It is ought to be mentioned that the two components are closely related.
The assessment is worked out by allocating different weights on 15 criteria, each using a binary value of zero or one. Then the overall index is structured by simply summing the resulting values. The economic independence may range from 3 to 13, while the political independence is supposed to range from 0 to six. Like the indices mentioned above, the higher the GMT index is, the more independence the central bank will have.
The third index is LVAU provided by Cukireman(1992) and Cukierman, Webb, Neyapti(1992) , which is probably the most widely accepted index of central bank independence.
This index states that the legal characteristics in a central bank's charter should be divided into four parts. The first one refers to the terms and appointments of the chief and other board staff, which help the central bank get rid of political pressures. In other words, a bank is considered as more independent if the chief executive is appointed by the central bank board rather than by the minister of finance. The second one relates to whether the central bank can formulate monetary policy freely and whether it has final right to determine its targets. The greater the degree to which policy decisions are made without government interference, the higher the level of independence. If a central bank's primary goal of monetary policy in its charter is price stability, then it states more independent. This is the third one. The final part addresses the extent to which the limitations on central bank lending.
However, in practice, legal methods of central bank independence would possibly not reflect the connection between the central bank and the government. If the rule of law in a country is less highly connected with the political culture, there can be big differences between the institutional formulations and their actual effect. Many developing nations is likely to be in this kind of case. Therefore, Based on work by Cukierman, it is common for developing economies to examine the turnover rate of the governors in the central bank, which is considered as an estimate of actual CBI. The lower the actual turnover rate, the more insulated a central bank from government, and thus the greater freedom in the conduct of monetary policy independently.
The Cukierman index is fulfilled by assessing 16 criteria of political and economic
independence grouped into 4 areas of issues. To be more specifically, they are Chief executive officer (CEO), policy formulation, objectives of central bank and limitations on lending to the government. Every variable uses a continuous scale from zero to one, with higher values indicating higher CBI. The overall index is based on a weighted average of the individual criteria. 72 countries have been thought about, and 21 of them are industrial countries and the rest are developing nations. The result indicates that the most independent central bank turns to be the Deutsche Bundesbank, whose CBI index is 0.69. By contrast, the independence index of central bank of Poland is only 0.10, which makes it the least autonomous central bank.
Alesina and Summer(1993) take both political independence and economic independence into account to develop another indicator which is expanded to three other questions. The first is whether the central bank is able to executeÂ§ monetary policy in the last step. The second is whether the governors stress on the central bank board. The final one is the number of members in the central bank are employed by politicians. Similar to his early research in 1988, this modified index is from 1 to 4.
Table 1 .A comparison of four different indicators
Source Cukierman, A., 1994. Commitment through delegation, political influence and central bank independence. In: De Beaufort Wijnholds, J.O., Eijffinger, S.C.W., Hoogduin, L.H. .Eds. , A Framework for Monetary Stability. Kluwer, Dordrecht, pp. 55-74.
The above indices are in similar rule although they have different criteria. And there is a quite interesting finding. When you rank the countries through indices, some of them may remain at different areas in different measurements. The table above compares the different criteria of the four indicators and the scale of them.
The main aim for this essay is to explore the relationship between central bank independence and inflation rate. The statistical evidence presents that countries whose central banks have higher level of independence are able to obtain lower inflation rate than their counterparts. These findings suggest that establishing an independent central bank is one concrete institutional reform that is ought to be accomplished as early as possible and may cut down inflation rate and thus boost economic growth. Governments that plan to reduce the independence of central banks should thus be aware that the final result of doing this may be the greater inflation level.
Although there is a negative correlation between CBI and inflation rate, it may also have some other native impact. Higher central bank independence may result in lower social welfare, since when a more independent central bank executes monetary policy, it will be more likely to concentrate on decreasing in output and government spending, rather than inflation rate, which may limit the source of welfare. Therefore, a further study can pay attention to the optimal degree of independence for a central bank.
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