Question

Generally, it is believed that central bank independence is preferred. But what exactly does central bank independence mean? Comment on this question by examining the types of independence.

Answer 1

Independence of the central bank refers to the monetary policymakers' freedom from direct political or governmental influence in policymaking. Primary developed economies endured extended periods of high inflation during the 1970s and early 1980s. To understand these bursts of inflation, account needs to be taken of why central banks have allowed them to happen. One influential line of argument pointed to the inflation bias inherent in discretionary monetary policy if the objective of the central bank for real output (unemployment) is above (below) the level of natural equilibrium of the economy or if policymakers simply prefer higher levels of output

Elected officials may be driven by shortrun electoral considerations or may highly value short-run economic increases while discounting expansionary policies' longer-run inflationary consequences. If elected officials' power to distort monetary policy results in excessive inflation, then countries that have central banks exempt from these interference will experience lower inflation levels.

The independence of instruments refers only to the capacity of the central bank to freely change its political resources in pursuit of monetary policy objectives. Although lacking target independence, the Bank of England has instrument independence; despite its government-mandated inflation mandate, it is able to set its instruments without government interference.

Firstly, a bank is regarded as more autonomous if the central bank board appoints the chief executive rather than the prime minister or finance minister, is not subject to dismissal, and has a long term of office. Such factors help the central bank separate itself from political pressures. Second, the greater the degree to which policy decisions are made independently of government involvement, the greater is independence. Third, a central bank becomes more independent if its charter states that the sole or primary objective of monetary policy is price stability.

Legal measures of central bank independence may not reflect the relationship that really exists in practice between the central bank and the government. There may be large differences between the formal, legal institutional structures and their functional effect in countries where the rule of law is less deeply rooted in the political culture. In many developing economies, this is especially likely to be the case. Thus, it is common for emerging economies to complement or even substitute central bank independence measures based on legal definitions with measures that represent the degree to which legally recognized independence is practically honoured.