Monetary Economics

Topic: Independence Of Central Bank

Submiited By:
Name: Mahnoor
Roll No: 78
Submitted To:
Miss Iqra
 In recent years there is a strong demand for central bank independence.
Monetary policy independence is not necessary primarily in order to protect a
‘conservative’ central banker from the influence that a less ‘conservative’
government might seek to bring to bear, but rather to enable central bankers with
a longer-term decision horizon (and a lower rate of time preference) to assert
their authority when faced with a government with a shorter planning “horizon
(and a higher rate of time preference).
Then, when the government ‘by a conscious act relinquishes its own power’, it
does not mean that the institution to which the power of decision-making is
transferred has different inflation and employment preferences from the
population, but simply that it is operating with a longer time horizon than the
government.
Thus, it is quite possible that the central bank will react appropriately to
temporary output shocks, if it is of the opinion that such a policy can be pursued
without long-term disadvantages for price stability. From this standpoint, the
economic rationale for independence is that it enables those deciding monetary
policy to conduct their policy without being always scrutinised by the
government for short-term results.

The longer term horizon in their decision-making implies that they make full
allowance for the long time lags involved in the conduct of monetary policy, i.e.,
its formulation and implementation.
It is now felt that the most important aim of central bank legislation should be to
create an incentive structure that guarantees a long-term time horizon of central
bankers. As most politicians are characterized by rather myopic behavior, this
implies, above all, that the monetary policy decisions taken in the central bank
have to be insulated from the general political process as far as possible.

This explains why central bank independence is now widely regarded as a

prerequisite for an efficient monetary policy. The trick is to attain the appropriate
balance between the need to be responsive to short-term pressures and the need
to ensure that those pressures are exerted in a system that safeguards the long-
term interest of the population. However, there are different definitions of central
bank independence.
Types of Central Bank Independence:
Two main types of independence are ‘goal independence’ and ‘instrument
independence’.

A central bank enjoys goal independence when it is free to choose its goals or,
at least, free to decide the actual target values for a given goal. A central bank has
instrument independence when it ‘is given control over the levers of monetary
policy and allowed to use them’.

An alternative definition distinguishes between political and economic

independence. By political independence we mean a central bank’s ability to
pursue the goal of price stability unfettered by formal or informal instructions
emanating from the ruling government. Independence refers to autonomy to
pursue the goal of low inflation.

Any institutional feature that enhances the central bank’s capacity to pursue this
goal will increase central bank independence. Economic independence means
that a central bank has unlimited freedom to determine all monetary policy
transactions that lead to changes in its operating targets.

Since all these definitions have both merits and shortcomings it is necessary to
make a synthesis of both approaches, which distinguishes three different notions
of independence.

1. Goal independence:
Goal independence requires that the government has no direct influence on the
goals of monetary policy.

2. Instrument independence:
Instrument independence requires that the central bank is able to set its operating
targets (interest rate, exchange rate) autonomously. This notion of instrument
independence is identical with the concept of ‘economic independence’.

3. Personal independence:
Personal independence requires that the decision-making body of a central bank
be in a position to resist formal directives as well as informal pressure from the
government.
Arguments in Favour of Central Bank’s Independence:

1. Governments tend to make poor decisions about monetary policy. In particular, they
tended to be influenced by short-term political considerations.
2. Before an election, the temptation is for a government to cut interest rates, making
boom and bust economic cycles more likely. Therefore arguably, it is better to take
monetary policy out of the government’s hands.
3. If the government has a track record of allowing inflation, then inflation expectations
start to creep up making inflation more likely.
4. An independent Central Bank may have more credibility. If people have more
confidence in the Central Bank, this helps to reduce inflationary expectations. In turn,
this makes inflation easier to keep low.
Arguments against the Autonomy of the Central Bank:
1. In Papers the autonomous central bank is also advocated, but practically no
central bank is completely autonomous, as it has to be linked with
government, president, assemblies and financial authorities.
2. In so many cases coordination has to be established between fiscal and
monetary policies. It may not happen that central bank is following strict
measures while govt. is purchasing easy fiscal policies.