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Macroeconomics is a crucial factor in every country’s economy since it monitors the performance, structure, decision making and behavior of the economy. To be able to understand the function of the economy then economists must study elements of economics such as; price indices, GDP, and unemployment rates; this will be important in elaborating national income, savings, consumption, investment, international trade, unemployment, output, international finance, and more importantly inflation (Wang, p.2). Most of these functions are entrusted to the central bank which seeks autonomy so as to effectively work everything out.
The central bank is mandated with implementing monetary policies, checking interest rates, controlling the supply of money, banks for the government and acts as the lender of last resort, administer foreign exchange, gold reserves, and the stock register, it supervises and regulates the banking sector and establishes the interest rates so as to manage exchange rates and inflation (Eijffinger, & Haan, p.3). Without independence these tasks will be manipulated to suit individual government or political needs hence plunge the country into financial catastrophe.
As cited by Alesina, & Summers, p.151 in the article “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence” Central Bank’s independence is different based on each countries policies; they also indicate that the more independent Central banks are the lower the levels of inflation. Central bank is also associated with such economic indictors such as growth, interest rates and unemployment while it generally upholds price stability.
The paper focuses on microeconomics especially on central bank independence and it advantages and disadvantages. It also consist of a review and critique of 5 articles related to the topic areas of macroeconomics and chosen from the Federal Reserve publications of the 12 different Federal Reserve District Banks over the period 2004-2010. It specifically tackles the topic on inflation and its relation to central bank independence. The two article used in the paper that are not in the 2004 – 2010 year bracket have been used to give a clear understanding on inflation and central bank independence. The two articles are Eijffinger, & Haan, in the working paper ‘The Political Economy of Central Bank Independence’ and Alesina, & Summers, in the article “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence”.
The independence of central bank
Independence indicates that central bank is free from any political, legislative, or executive control of the government. It also indicates that it is free from private or groups control in that it never serves the interest of few individuals but rather the whole nation. It should therefore be free to undertake its mandate without external pressure that may stall economic progress and monitoring (Alesina, & Summers, p.152).
The most sensitive role of central bank of producing currency or money for a country emphasizes the very fact that it should be autonomous in that it should not be controlled by any elected persons rather than professionals with the interest of the country at heart. This will avoid manipulation of the central bank operations for short term political ambitions. Accountability is stressed in all its operations so that its operations of monetary policy and price stability objective can be attained without prejudice.
When the power to create money is merged with the power to spend there is possible misuse and abuse of the power to create money. This can be seen where governments control the central bank where more money is printed during election periods which boosts employment and spending 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 create money 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 growth since no policy is compromised to suit political interests. The professionals operate on the long term and thus decisions on interest rates and money matters are made appropriately on the mandate that will benefit the society Eijffinger, & Haan, p.11. Central bank independence has been 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 an overall 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 the economy (Alesina, & Summers, p.154). Democracy has also made independence of central bank compromised since it dictates that there is need for accountability to elected leaders and hence in one way or the other central bank must be controlled by the legislature.
For central bank to remain independent there must be a comprehensive legal and operational structure that outlines the monetary structure that should be followed; this should be devoid 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 necessary that will be proof of accountability in all departments. The public will also be able to assess 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 are made and implemented effectively and without any interference from political entities. The decisions to be made and implemented include; functional independence (right to make decisions on monetary policy and price stability), personnel independence (including free selection of the board of trustees), instrumental independence (control of all elements of inflation such as preventing financing of government insufficiency) and financial independence (that ensures central 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 lower rates of inflation. According to Eijffinger, & Haan, p.12 in the working paper ‘The Political Economy of Central Bank Independence’ there are three explanations that explain the phenomenon of central bank independence being associated with low inflation rates these include; public choice argument, the study of Sargent and Wallace, and the time inconsistence crisis of monetary policy.
The public choice perspective indicates that authorities dealing with monetary policies are exposed to pressures from political spheres so as to fulfill government objectives. Due to monetary constraints makes the government adjust the budget. This is through reduced tax income due to temporary economic slowdown lowers the seigniorage and public debt burden in the short run. This makes the government prefer the easiest way to obtain finance which is through central bank (Eijffinger, & Haan, p.15). This will not be the case if central bank is independent.
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 monetary authorities. If the public taxes also does not then finance the debt the budget is constrained thus central 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 of its effects.
Time inconsistency also account for inflation is time inconsistency, where plans made for the future become unviable with the start of the period budgeted for. The government and the public must be able to cover the lost time thus the government applies incentives thus remains at a 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 the monetary policy primary goal set as a commitment to price stability while other goals are subordinate; third is the use of many variables to decide the setting of the instruments of the policy through an informative strategy; fourth is transparency guarantees that is cultivated through continuous communication with the public on the monetary policy; and fifth is the accountability 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 benefits as time passes.
Cohenâ€Cole, & Cosmaciuc, p.1 in the working paper ‘In Noise We Trust? Optimal Monetary Policy with Random Targets’ addresses the issue of monetary policy that the central bank uses to achieve randomized inflation targets rather than fixed targets that have a faster potential of convergence. For transition environments randomized are observed to achieve faster convergence. Cohenâ€Cole, & Cosmaciuc, uses two ideologies to explain the monetary policy where 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 transition environments.
Inflation targeting systems generally contribute to a decline in rapid inflation in conditions of hyper inflation. This is contributed by bolder objectives of inflation targets and more importantly presence of skillful bankers who implement the objectives. This can only be achieved through independence of the central bank where there is no interference with the operations and management (Hornstein, p.317). The autonomy will be effective since short term goals of inflation targeting set by politicians for personal gain will be eliminated thus controlling inflation and other aspects of the macroeconomics.
The bankers must also be credible enough to the public such that pronouncement of low inflation policy will be taken into consideration. In the event the bankers are not credible their pronouncements 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 regimes are changing guards there are always high expectations from the population that must be addressed by the bankers without prejudice.
For incoming governments setting inflation rates at randomized figures makes them credible; this is so because the inflation targets from the previous regime may be lower and thus setting higher levels of inflation will make then incredible (Hornstein, p.317). Therefore, the government results to set an inflation rate that is random rather than fixed so that to avoid any commitments, the public may take it that the figures that are randomized will be lower than the previous regimes thus the previous regime gains population confidence. When such regimes are allowed to control central bank this will result to short term political ambitions that may plunge the nation to financial crisis.
In Cohenâ€Cole, & Cosmaciuc, p.3 “Monetary policy randomization has potential application 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 is clearly desirable, especially since most “losses” occur in the short run.”
The objective of central bank is to stabilize domestic inflation and also the output gap given a flexible inflation target regime this means that they must be able to adjust domestic interest rates that will not be affected by foreign interest rates. This is the major reason that central bank needs monetary autonomy (Mukherjee, p.5).
The macroeconomics trireme states that at most two of the three conditions stated below can be chosen in the inflation of small open economies; these are, “Autonomous monetary policy in the sense of different domestic and foreign interest rates, a fixed exchange rate and/or Perfect capital mobility” (Mukherjee, p.5). The autonomy of the monetary policy is where the central bank is independent to carry out the required operations.
Inflation targeting is applied by central bank to give the public an estimate of the inflation rates targeted by the bank. These targets are then achieved through changes in interest rates and other monetary options (Williams, p.4). Interest rates and inflation tend to be inversely proportional hence in the event that inflation is higher than expected lowering the raising the interest rates will reverse the inflation. When inflation is lower than targeted lowering the interest rates is the expected move so that inflation can rise.
This policy can be employed by central to control aspects of macroeconomics. The knowledge of inflation targeting makes investors have an idea of what the central bank targets of the inflation rates are thus they can easily the approximate changes that interest rates will be subject to thus plan appropriately on their investments (Wang, p.5). The investors are also confident about their investments in view of the fact that they can plan so that the inflation rates do not impact negatively on their businesses. This has positive effects in that investor confidence translates to a stable economy of the nation. For states that practice inflation targeting most of them are successful given that the markets are predictable and accountable which attract numerous investors. The Federal Reserve’s policy has been involved together with the Federal Open Market Committee (FOMC) in the targeting of inflation which is not an exact explicit figure.
The inflation targeting framework should not be just based on announcing figures the management of central bank should ensure that the announcement to the public gives the medium and long term objectives for inflation which may be given as a point or varied range. It must also be institutionally committed to stabilizing of price as a primary objective supported by other goals. Giving price stability a priority gives credibility to central bank so as to attain the inflation 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 that there 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 decisions made should be accounted for. The public must be kept in the know so as to achieve the required credibility, as Cohenâ€Cole, & Cosmaciuc, p.3 quotes ‘The public does not have knowledge of the government’s methods or desires, but is able to learn from the government’s prior actions. This is an abstraction that seems appropriate in a situation of low government credibility. Essentially it assumes zero credibility – any announcement is equivalent to none at all. The public derives all new information from the actions themselves’. To achieve inflation targeting the government should not have or should have minimum burdens of financial deficits in its budget and most important 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 perfect knowledge however in the actual business environment there is imperfect knowledge. Williams, p.2 in his article ‘Inflation Targeting under Imperfect Knowledge’ identifies factors that impact on inflation targeting in circumstances where there is imperfect knowledge.
Policy makers are not sure on the evolution of natural rates; for example natural rates of interests and unemployment are never predictable hence operation in imperfect knowledge for most economies (Williams, p.6). This gives a challenge to the small economies that base on inflation targeting since it may result to errors thus hinder stability. The economic structure is also uncertain and thus policy makers rely on estimates.
Macroeconomics and inflation targeting
Many central banks target on lowering inflation and its volatility as the primary objectives while other objectives of output are sidelined, but most of those who use inflation targets 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, distribution of income and poverty (Sierra, & Yeager, p.47). Though many countries target inflation it has remained low even in those countries that use other monetary policies other than inflation targeting this does not mean the inflation targeting is not effective but it sets the records straight that inflation targeting can be affected by other secondary factors beyond central banks.
The credibility of central bank is also at stake if the targets are not achieved this means that effective policies must be ensured by the experts to make the sacrifice ratio to count. Factors that might affect inflation such as exchange rates must be monitored effectively so as not to negatively affect the inflation targets (Sierra, & Yeager, p.49). Proper coordination between economic policies and the monetary policy would ensure that all targets of growth are met since lower 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 for consumer products normally assumes that there is money supply in the economy. Oil as a major commodity has increased in price at different times resulting to increase in prices of other consumer products the basis of inflation to measure growth would be misleading since they are subject to numerous fluctuations (Sierra, & Yeager, p.53). However a stable financial environment there is an imperative precondition that fosters economic growth and development.
Inflation targeting mainly aims at price stability and when this is achieved there is protection of currency from fluctuations which in turn contribute to sustainable growth. Inflation has implications on the distribution of income and wealth this in view of the fact that the wealthy have the means to buy non monetary assets thus protect themselves from inflation. When unexpected inflation occurs those who have saved and those earning fixed incomes are affected most while borrowers benefit. High inflation drives the prices of consumer able products high and 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 account for inflation. When income rises with inflation it will lead to higher taxation thus reduces monthly incomes for earners. Unmonitored inflation levels in any country will impact on the decision making processes. It will be difficult to make decisions since inflation levels and price stability is uncertain. This translates to poor development and growth since price systems are unpredictable and thus less efficient. With a stable inflation rate many investors are confident and this leads to numerous investments that lead to growth and development.
Many analysts may argue that inflation targeting may have its negative impacts of high unemployment in the short run but benefits in the long run will supersede those achieved by other policies. Inflation targeting does not only target stable prices but also contribute to the growth and development of all the macroeconomics of a region but this is achieved with an independent central bank.
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.
Cohenâ€Cole, Ethan & Cosmaciuc, Bogdan. In Noise We Trust? Optimal Monetary Policy with Random Targets. Working Paper No. 06â€14 Federal Reserve Bank of Boston. (October 2006). http://www.bos.frb.org/economic/wp/wp2006/wp0614.pdf
Eijffinger, Sylvester C.W. & Haan, Jakob D ‘The Political Economy of Central Bank Independence. Special Papers in International Economics No.19. (May 1996).
Epstein, Gerald & Yeldan, Erinc A. Inflation Targeting, Employment Creation and Economic Development. G-24 Policy Brief No.14. (2009)
Hornstein, Andreas. Evolving Inflation Dynamics and the New Keynesian Phillips Curve. Economic Quarterly. Vol.93, (4) (2007): p. 317-339.
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Mukherjee, 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
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..
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>
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