Central bank independence and economic performance - Assignment Example

? Central Bank’s independence and economic performance ID number: Table of contents Executive Summary 3 Introduction 4 Role of central bank 4 Central Bank’s independence 4 Central bank and economic performance 6 Conclusion 8 Recommendation 8 Reference 9 Appendix 10 Central Bank’s independence and economic performance Executive Summary Central bank regulates money supply and interest rates through its monetary policies. This paper seeks to analyse the role of central bank in terms of economic performance of the nation and how independence of its operations is an important factor in this context in achieving its objectives. The main objectives of the monetary policies of the central bank are to keep inflation under control and unemployment rate low with a view to stimulate and maintain economic growth in a nation. In order to achieve economic growth in a country, formation of capital is essential for fresh investments in the economy. Increase in aggregate demand in the country is an important factor in this regard for attracting investment of capital in new projects. Liquidity in the system as well as interest rates should be monitored and regulated on a continuous basis by the central bank to provide good environment for capital investment and consumption which in turn will generate demand for the products. However, the central bank should also ensure that it does not result in overheating of the economy. The independence of the central bank of the county is very important for exercising control over the commercial banks in the country through its monetary policies. Healthy banking sector in a country is a prerequisite for good economic performance of the nation. The monetary policies need to be complementary to the fiscal policies of the government to achieve its economic objectives. The fiscal policies are long term in nature. The success of fiscal policies is to a larger extent dependent upon efficient banking system in the country. Introduction Regulating interests and money supply in the economic system is very complicated in the backdrop of technological developments taking place in the world and globalisation of economies. Convergence of technologies has changed the face of international banking with sophisticated products and processes. For instance under the floating exchange rate regime, protecting the value of the domestic currency against US Dollar and other international currencies calls for vigilance and continuous monitoring of the world economy through various economic indices. Regulating money supply and interest rates are governed by several domestic and international factors as well. Therefore, independence of the central bank is necessary to deal with these problems effectively without any interference in the regulatory process. However, the level of independence varies from country to country based on the political and economic system prevailing in the countries. Long ago in 1929 Montagu Norman, Governor of the Bank of England wrote: “I look upon the Bank as having the unique right to offer advice and to press such advice even to the point of nagging: but always, of course, subject to the supreme authority of the government” (Toniolo, G. 1988 p. 47). This statement underlines the need for independence as well as its limitation. The role of central bank Central bank’s monetary policies have different impact on different economic variables of the economy. Increase in money supply with or without decrease in interest rates could trigger inflation in the economy. Therefore, careful analysis of the economic indicators is important in taking appropriate action by the central bank. For instance, inflation in this case could affect consumption thereby demand for the products. At the same time, this could increase capital investment and results in employment generation. Stability in exchange rate is another important factor which could affect inflation in the country and foreign direct investments in the country which will have impact on the economy. The central bank adopts several techniques to maintain liquidity and stability in the markets which include specifying reserve requirements and buying and selling securities in open market operations. Monetary policy is a balancing act intending to yield the desired effect in economic performance of the nation. Independence in exercising its authority lends flexibility in the operations of the central bank to keep in tune with the economic development based on the economic indicators such as jobless claims, consumer price index and trade balance position. Central Bank’s independence Smaghi, B. (2007) stated “the legal provisions are necessary, but not sufficient to ensure central bank independence... Central bank independence is a way to protect policy makers against the temptation of using monetary policy in a distortionary way. However, the temptation is not eliminated. This might be a reason why central bank independence appears to be strongly supported by the citizens.” The degree of independence enjoyed by the central banks of different countries of the world varies considerably. The central bank should be provided with explicit mandate to deal with inflation in a country for maintaining stability in the prices. The independence of the central bank has been subjected to restrictions in the United States on several occasions in the history of Federal Reserve, especially in the aftermath of great depression, only to be restored its independence later. Independence to the central bank precludes neither consultations with the government nor coordination with the government for exercising its monetary authority keeping in tune with the fiscal policies of the government to achieve the common economic objectives of the nation. Independence to central bank is necessary to insulate the country’s economy from political developments. This will avoid manipulations of monetary policies, especially during pre-election times by the ruling party with a tendency to declare populist measures to woo the electorate. The economic variables such as such as growth, unemployment, and real interest rates are highly interlinked and interdependent. Monitoring of the system, consequently the regulatory function is a continuous process. Government interference in this process will be detrimental to the continuity of the process and will affect the economic performance of the country adversely. Central bank and economic performance Regulation of supply of money and interest rates in an economy is carried out after taking into account the impact of these decisions on economic variables such as inflation and unemployment with the aim of achieving economic growth. During economic slowdowns, increasing money supply and reduction in interest rates propel demand for the products. Increase in consumption leads to increased demand. To meet this increased demand, investments are made in new projects that cause employment generation. Creation of employment opportunities fuels further demand due to multiplier effect. But, in an economy where the proportion of pensioners is ever increasing, reducing the interest rates beyond a limit will affect the pensioners’ income. Government spending and taxation are the important tools used by the government for economic growth. Increased government spending as well as reduction in the tax rates increases money supply into the system. Increase in government spending also creates employment in the country which will drive up the demand for the products. Therefore, economic performance depends upon efficacy of both fiscal and monetary policies and monetary policies should take the impact of fiscal policies also into account in formulation of its policies. When the economy is overheated, in order to bring down inflation pressure in the economy, money supply will be tightened and the interest will be raised. This will affect aggregate demand. Monetary policy is a double edged sword, and this balancing act inevitable. Fiscal policies of the government and the international developments will also have their impact on the economic variables. But, the central bank has no control over such factors. The government may be constrained in fiscal front due to factors such as accumulated budget deficits and international developments such as increase in crude oil prices. In spite of the limitations, over which the central bank has no control, effective implementation of monetary policies by the central bank ensures stability in liquidity and prices in the economic system in the normal course. According to a study by Mathew, J. T. relating to central bank independence in twenty five countries (Annexure -I) “it is clear that the Germany (33.5 points) has got the most independent CB in the world followed by United States (32 points); Chile (31 points); and Peru, Switzerland (29 points). On the other hand India (17.5 points) has got the least independent CB next to the Indonesia (20 points); Mexico (21.5 points); and the United Kingdom, South Korea (22.5 points)” (2001, pp. 18-20) as per the index. In this study attributes relating to law and practice in respect of Monetary Policy Independence (MPI); Personnel or Political Independence (PI); and Fiscal or Financial Independence (FI) have been considered (p. 13). It could be inferred that by and large, there is close relationship between CBI and inflation and where there is higher independence, annual rate of inflation tends to be lower. Conclusion The statement made by Fraser, B. W. (1994, p. 1) “Many of the ‘transitional economies’ of Eastern Europe also have adopted reforms aimed at making their central banks more independent” clearly indicates that autonomy to the central banks in regulating money supply and interest rates has gained importance over the period of time for infusing efficiency in economic performance of the nation. This autonomy insulates the operations of central banks from political intervention. Taming inflation is a complex phenomenon and cannot be achieved only through the monetary policies pursued by the central bank of the nation, because fiscal and labour policies of the government are also the important determinants in this regard. Close coordination between the central bank and the government is essential to achieve the intended economic objectives of a nation on a long term basis. While independence to central bank ensures accountability in its operations the need to exercise their authority within the statutory and legislative framework cannot be undermined. Recommendation A country with high central bank interference need to introduce reforms to make the institution more independent within the timeframe set for this purpose to improve stability in liquidity and prices. Independence of the central bank needs to be discussed in terms of accountability for making it more effective. Therefore, appropriate framework for this purpose should be proposed in the back drop of legal and political structure of the country, debated and established. Establishment of the framework for design and implementation of monetary policies is the first step in this process to ensure accountability of the central bank. Apart from the policy objectives, other important factors to be considered in this process include review of the existing system of evolving monetary policies, working out the basic parameters of monetary policies and establishing procedures for appointment of officers responsible for design and implementation of the monetary policies. References Fraser, B. W., 1994. “Central Bank Independence: What Does It Mean?” Reserve Bank of Australia Bulletin. Available at: http://www.rba.gov.au/publications/bulletin/1994/dec/pdf/bu-1294-1.pdf> [Accessed 26 November 2013]. Mathew, J. T., 2001. Measuring Central Bank Independence in Twenty- Five countries: A NewIndex of Institutional Quality. Available at: [Accessed 26 November 2013]. Smaghi, L. B., 2007. Central bank independence: from theory to practice. Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB at the conference Good Governance and Effective Partnership Budapest, Hungarian National Assembly, 19 April 2007. European Central Bank. Available at: [Accessed 26 November 2013]. Toniolo, G. Ed., 1988. Central Bank’s Independence in Historical Perspective. Walter de Gruiter. Berlin 30. Appendix Annexure – I CBI and Inflation Rates in Developed and Developing Countries Country/Aspects MPI PI FI CBI CBI Ranking Rate of Inflation United Kingdom 8.5 2 12 22.5 15 1.8 New Zealand 9 5 12 26 9 2.7 Canada 10 5 8 23 14 2.6 Sweden 11 6.5 8.5 26 9 2.4 South Korea 10.5 4.5 7.5 22.5 15 4 United States 10 11 11 32 2 2.8 Australia 7.5 4 12 23.5 13 4.4 Italy 7.5 7.5 10.5 25.5 10 2.7 Spain 10.5 5 12 27.5 6 3.6 Finland 9.5 5.5 11.5 26.5 8 2.5 Switzerland 10 7.5 11.5 29 4 0.96 France 9.5 8 11 28.5 5 1.6 Germany 12 10 11.5 33.5 1 2.3 Brazil 8.5 7 11.5 27 7 6.8 Thailand 11 3 11.5 25.5 10 1.7 Czech Rep 10 4 10.5 24.5 11 4.7 Chile 12 11 8 31 3 3.6 Poland 11 5 8 24 12 5.5 Indonesia 5 8 7 20 17 11.5 Israel 9.5 5 11.5 26 9 1.2 South Africa 9.5 6.5 7 23 14 5.6 Malaysia 8.5 4 11 23.5 13 1.4 Mexico 10.5 5 6 21.5 16 6.3 India 6.5 2.5 8.5 17.5 18 3.6 Peru 10 10 9 29 4 2 Source: Mathew, J. T., 2001. Measuring Central Bank Independence in Twenty- Five countries: A NewIndex of Institutional Quality. 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