The Concept Of Central Bank Independence: Meaning, Mechanism, And Importance

Discussion

This piece of work will focus on the long debate about whether government officials must be given the power to influence the interest rates and growth in any economy or the central banks must be given complete independence (Vonessen et al. 2020). It is often argued that a politician cannot be completely trusted. Just before an election, they can lower the interest rates in an economy to lower the prices of goods and services. This, as a result, will escalate to create more jobs, and the macro-economy will experience growth. However, if more people get employed, they will contribute further to the total demand of any economy, resulting in a higher price level; that is, inflation. Then once the politicians win the election, they will lower the interest rates to control the said inflation (Andrade et al. 2018). As it is already mentioned that in most cases, the citizens stay dubious of the politicians if they can coordinate the interest rate, taxes and growth properly or not, experts have suggested that the better economic measure will be to give the central banks the right to operate independently of the government to bring equilibrium in an economy.

The concept of central bank independence is a socially accepted agenda all over the world. After all, macroeconomic issues like interest rates, taxation, inflation, employment and growth can only be dealt with by monetary policies. For decades several monetary adjustments had been made by the central banks all over the world, which did correct the fluctuations in those economies. This section of the paper will delve deep into the entire concept of central bank independence (CBI).

Independence is a subjective and relative term all over the world. The same thing applies for CBI (Kern, Reinsberg and Rau-Gohring 2019). Legally, independence can be subdivided into four parts, namely, quasi-constitutional independence, institutional independence, personal independence and financial independence. The quasi-constitutional independence of the central bank generally involves a treaty. Like, in the European Union, the treaty stated that the European Central Bank would operate independently for the member countries of the EU. In other words, none of the allied countries can repel against this term. On the other hand, due to a lack of a codified constitution, the Bank of England is not independent of politically imposed legislations. The institutional independence signifies that the central banks are free in performing their tasks, and the government executives do not have a say in that. For example, the BOE has three committees that are constructed in accordance with the parliament legislation, and the functioning is target-dependent (Haldane and Michael 2018). The same thing for the EU is target independence. The third part is personal independence, according to which individuals are given security based on their appointment qualification and ability to take charge of the decisions. This entire process gets supervised by the parliament and treasury committee. The final independence subpart is financial, which means the central bank can get involved in monetary financing and has the ability to achieve the goal using all available resources.

Definition

As already mentioned in the paper, the concept of central bank independence has been up for debate for the last few decades. Among all the arguments, there are four primary incidences that influenced this dynamic the most. Firstly, for the 1970 inflation, the central banks were held accountable for their incompetency (Ha, Kose and Ohnsorge 2019). Experts suggested that the functionality and operations of these financial establishments needed modification. Secondly, developed, fresh out of foreign rule and transitory nations in the 20^th century were either establishing their central banks or reconstituting the existing ones’ operations. Therefore, it became absolutely necessary for those countries to clearly determine the relationship between central banks and the government entities, more in the post-war periods. Thirdly, rationality in the macroeconomic policies developed the need to have more emphasis on the monetary policy development; for this purpose, the ability of central banks to pass on policies came to light. Finally, statistics during the late 1990s showed that nations in where the central banks were independent of government intervention performed in a better way the economic stability and growth in those nations were better than others. Therefore, it can be said that the CBI concept was not developed on a whim. Rather, it came to light because the international economy in the last century was in serious need of the same.

The above segment discussed the meaning of central bank independence and why it became necessary to introduce this dynamic in the international economy. This section is going to discuss the mechanism of the concept itself. The CBI is, although seemingly pretty straightforward, its implementation has certain layers (Masciandaro, Magurno and Romano 2020). The first layer is to put a stop to political involvement while determining the board and members of any central bank. The second layer is freeing the central banks in performing their financial functions without any government suggestion and influence. The third layer is the autonomy of central banks during the imposition of monetary policies so that the banks can set their own objective and boundaries while addressing any economic event.

During the last decades of the 20^th century, the relationship between inflation and growth was starting to get acknowledged, and its necessity in studying a nation’s economy was addressed. According to the Phillips Curve, there is a negative relationship between inflation and unemployment (McLeay and Tenreyro 2020). If unemployment is lower, that is, more people get job opportunities, then they will have extra cash to accelerate the market demand. However, the supply might not be adequate to meet the increased demand. As a result, product prices will rise, and there will be an increased flow of money than what it was supposed to be; in other words, inflation. Nevertheless, this is a short-run scenario. In the long run, if there is an excessive money supply in the economy to lower the unemployment further than the natural rate, then that will result in an inflation bias. Consequently, there will be no economic growth and business entities to accommodate this inflation bias will increase the remuneration of existing workers rather than hiring new ones. This is where the central bank comes to light, and their independence attains great significance.

History and background

When a country goes through a rough patch of inflationary situations, every government executive wants to relax the monetary measures like interest rates and taxes so that the economy can have a higher level of output and employment. Experts like Friedman, Barro, Gordon, Rogoff and others in their past literature had suggested that inflation can only be controlled through measures like growing the money stock consistently, averting inflation using a conservative central bank and a penalty charge for the central banks if the economy starts operating with a high inflationary rate (Adodo, Akindutire and Ogunyemi 2018). Although these measures can be somewhat effective in adjusting inflation, there can occur several monetary shocks all over the economy. Hence, if the central banks are responsible for making corrections to the economy without any external input from any political and government sources, then the inflation adjustment and growth scenario will be much better. An independent central bank can set its own target and determine instruments that are best suitable to achieve the same. In this way, the country’s economic welfare will be higher than in the previous case. As the central banks get the liberty to operate as an autonomous entity, they can impose monetary policies that will improve the efficacy in an economy, and the short-run exploitation of the inflation and unemployment trade-off will be way lower. During the period 1970-2000, nearly every developed nation initialised their price stabling monetary policy mandates and central banks were made independent and accountable for those policy mandates (Garriga and Rodriguez 2020).

It is often said that no matter how many positive attributes are present, every small thing in this world has a certain disadvantage. The CBI is also not free of challenges. The global financial crisis of 2007 is an example of it. Before that, the main objective of the monetary policy implementations was to attain price stability in the economy. The GFC made it clear that price and financial stability go hand in hand. In other words, it is practically impossible to address and ignore the other. Thus, from 2007 onwards, additional emphasis was given to financial stability while addressing monetary policies (Eddison Walters and Djokic 2019). That is, the power of central banks was expanded to make adjustments even in the microeconomic aspects of a country. However, the said expansion created several controversies about the efficiency of the CBI. The first one was insufficient accountability that arose after the operational expansion of the central banks. Experts argued that the objective of financial stability is more complex than that of price stability. Thus, mapping out central banks’ accountability became more complex than before. Secondly, conflict of interest could be another challenge. If the banking system in any country is poor, the interest rates will be preferred low, resulting in higher inflation (Blanchard 2019). Thus, it became difficult for the central bank to align its macro and micro-prudential objectives. Thirdly, there are a lot of cases when policies require government inputs. Thus, it is not possible for the CBI to maintain its boundaries then. Fourthly, it is debated that if the commercial banks get a higher lending and lower collateral along with the purchase of non-traditional assets, then there will be a risk loom above the states’ consolidated balance sheets. Apart from these major shortcomings, there are several others like concerns regarding distributions, excessively powerful central banks and attacks against the CBs for their lack of quality services (Masciandro and Romelli 2018).

Conclusion:

Therefore, it can be said that the central banks can work better if they become independent entities and their area of operation gets expanded. Since the middle period of the last century, this debate is consistently getting argued. There are several advantages to this independence, although those are not completely free from criticism. It will take several years more to come to a neutral ground. Until then, it is better to let the central banks operate according to the need for the economies.

References

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