Macroeconomics for Banking and Finance Coursework

AFEAEM734 Macroeconomics for Banking and Finance Coursework

Explain, with reference to one real world example, the role played by central bank independence in improving inflation performance.

Introduction

The aim of the assignment is to evaluate and analyse the role played by central bank independence, henceforth CBI, in improving or lowering inflation.

There have been countless investigations into this and the general consensus points out that the relationship between CBI and inflation is negatively correlated, meaning that the more the degree of independence a central bank has the lower the inflation.

However there have been questions raised regarding the above hypothesis, which I will touch upon throughout the assignment.

For example does the same level of independence in a developed economy produce the same level of price stability in a transitional economy. An article from the World Bank Policy Research Bulletin comments that in a report carried out by Cukierman, Webb and Neyapti, "The more independent the central bank, the less the inflation---in industrial but not in developing countries. In the developing countries, the infrequency of change of the chief executive officer of the bank is a better proxy for the central bank independence. And an index of overall central bank independence explains much of the cross-country variation in inflation". (www.worldbank.org/html/dec/Publications/Bulletins/PRBvol3no5.html).

This can also be supported by Ismihan and Ozkan (2003, p2) who go on to say that empirical evidence for the negative correlation in developing countries has been less clear-cut.

Another important factor is whether price stability is achieved through sacrifice of other macroeconomic objectives such as economic growth and full employment. There has been empirical research carried out to find whether there is any link or trade-offs between inflation and other important macroeconomic variables.

An article by Fischer points out that there is a short-run trade off between unemployment and inflation and suggests that shouldn't the central bank be given the task of maintaining full employment together with that of maintaining low inflation.

A short-run trade-off also exists between reducing the variability of inflation and the variability of GDP growth. In the same article, Fischer found that the link between growth and inflation is negatively correlated at double-digit inflation rates even though there have been claims that inflation may be good for growth. (www.worldbank.org/fandd/english/1296/articles/0101296). This goes against the view of the governor of the South African Reserve Bank (SARB) Tito Mboweni who argues that the link between CBI, inflation and long-term growth is a positive one.

"Independent central banks are more likely to achieve lower growth because politicians have less opportunity to manipulate interest-rates for short-term political gain. Low inflation is good for long-term growth". (www.economist.com.na/2003/17oct-10-17-06.htm).

As the relationship is a negative one, there is a tendency for policy makers and politicians to push the economy to run faster and further than its capacity limits allow and the temptation that governments have to incur budget deficits and fund these borrowings from the central bank. This poses questions whether CBI really influences lower inflation. The theory of inflationary bias suggests whoever is in charge of price stability may rise the levels of inflation to exploit the short-run trade off between output and inflation.

A speech by Governor of the Reserve Bank of Australia, Fraser, B.W., suggests that the politicians are to blame for inflationary bias, claiming that they have short-time horizons instead of long-term goals.

A further test by Alesina and Summers (1993, P154) investigated the relationship between central bank independence and the level or variability of economic growth and found to be no relationship. "Germany and Netherlands which also have relatively independent central banks have relatively good economic performance. On the other hand, countries with relatively dependent central banks such as Spain and New Zealand have relatively variable economic growth whereas France with a relatively dependent central bank has enjoyed steady growth".

Another important factor, which may lie behind the negative correlation, can be put down to individual countries performances with inflation in the past. In his speech, Fraser comments on Germany and the independence of the Bundesbank, for example, are both related to the inflation aversion of the German people following the experience of hyperinflation in the 1920's.

The introduction suggests that there is a negative correlation between CBI and inflation but with questions inevitably asked about the relationship. The assignment from now on will look at empirical research regarding central bank independence and how in one country the degree of CBI has improved inflation performance.

The following graphs from Alesina and Summers empirical findings sum up the near perfect negative correlation between CBI and inflation.

Role of Central Bank Independence

There are many research reports undertaken that suggest that the sole role of an independent central bank is price stability. Of course for a central bank to be successful in lowering inflation, it must have the minimum of interference from the government. Fuhrer (1997 p22) uses Debelle and Fischer (1994) to clarify the definition of a successful independent central bank. The distinction is made between goal independence and instrument independence where the former allows the central bank to set its ultimate goals (price stability) and the latter allows it to determine the appropriate setting for its instrument (bank reserves) in order to achieve ultimate goals. The Reserve Bank of New Zealand has a very specific goal of pursuing an inflation target between zero and two per cent.

This can also fit in with Alesina and Summers (1993,P153) who use political independence and economic independence as their ways of measuring central bank independence. "Political independence is defined essentially as in Bade and Parkin (1982), as the ability of the central bank to select its policy objectives without influence from the government".

Economic independence is defined as "the ability to use instruments of monetary policy without restrictions". As we will see