Central Bank Independence and Inflation - Statistics Project Example

Central Bank Independence and Inflation Student’s Name Course code and name Professor’s name University name City, State Date of submission Introduction Inflation bias is the result of a government discretionary policy that when analyzed keenly under the labor market results into an inflation level, which is higher than the optimal one. It also causes an income increase that is transitory. In addition, this term may also stand for a public debt ridden practice in a certain nation where the enacting policies which encourages inflation are followed (Blinder, 1998 p 98). In order to understand these terms fully it is clear that central banks are one of the vital fiscal theory and strategy concepts. It is helping in reaching the long term goal instability of prices. CBI is the most recommended form of inflation control with a big percentage of countries in the world making them independent. This paper will try to address more on this term, and will try to prove whether countries with central bank’s independence has a close link to a low inflation cases. Discretionary Policy-Making This can be analyzed by use of two simple models. In this case, Romer indicates that inflation rate has an inverse relationship to the openness degree of the economy in a country. These findings are attributed to the monetary surprise benefits gained in terms of real output that are smaller than the trade orientation in an open economy. On the other hand, Lane dispute is due nominal price inflexibility fact that there is existence and a flawed competition within the zone that is non traded and not the trade term effects that Romer suggested. It is clear that the inflation bias in the discretion policy has an inverse relationship to the supply of real output sensitivity. However, it has to respond to the available changes in the exchange rates (Calvo, 1978 p 59). All these are aimed at showing what forced many governments to have independent central banks as an inflation measure. Inflation Bias The size of inflation bias requires some highlight on the significance of aggregate contribution effects based on discretionary policies that make this system. Inflation bias has forced many countries to provide their central banks with extra freedom as a weapon to lower the inflation level (Blinder, 1998 p 58). This relationship can be shown by use an open economy model where foreign resources are being imported. The model aims at showing that, under a discretion state; the inflation bias has a converse relationship to the elasticity of the output being supplied in accordance to definite exchange charge (Blinder, 1998 p 18). These findings are according to Romers empirical result of 1993, which confirmed that there is existence of negative association in between inflation and openness. Discretion and rules to be followed have been a key monetary policy debate for a long time. Several economist beliefs have been deemed relevant, for example, Barro and Gordon of 1983. These two economist views that there exists an inflation bias in the operation of monetary policy fell under two main views: Concerns on the standard analysis of the discretionary behavior in the monetary policy sector show that there is need for the monetary authorities to lower the unemployment rate through the use of inflationary policies. However, this procedure is barred by effects caused by an increase in the monetary supply on unemployment rates in the long run (Ireland, 1999 p 177). This shows that if rules were to be an inflation bias manifestation would be impeded indicating presence of more preferable outcome that is more than that of the discretionary behavior. Therefore, under this view the most important institutional framework that is competent in lowering the discretionary government actions is through the application of independent agencies in the economy, for example, independent central banks. The second point of view is on political application of monetary policy. This can be based on political electro cycle and the fiscal dominance of an economy. The analysis implies that there is relevant distinction between the monetary and fiscal authority. That is if the public fails to pay extra deficits in the economy the monetary authority has no option other than being forced in financing the government by expanding the money supply. However, if the monetary authority has dominance over the public, the fiscal authority will have the obligation of reducing any deficit (Ireland, 1999 p 87). For example, during elections governments prefers more employments opportunities than inflation rates. This means that the monetary authority is forced to implement policies that aim at increasing the output. It also shows that the existence of a central bank that is subservient tends to have an increase in the supply of money aiming to reduce the unemployment level. These two views by Barro and Gordon give a brief assessment for the conformist inflation bias together with the Cukierman's new inflation bias. On the other hand, inflation balance in the economy is likely to occur once there is lack of balance of payment equilibrium. There is a mixture of opinions from several economist most of them suggesting that having a conservative central bank is a major option in controlling the inflationary bias (Ireland, 1999 p 87). However, there is a contingency fact that the government can be overruled by an integral part of the monetary policy process. In the year 1993 and 1995 person and Tabellini raised a proposal on the contingent contract whereby the central bank got punishments in case the inflation rate or target exceeded the set rate. Independence of Central Bank and Inflation Independence in most central banks is a reference of the liberty given to the designers of a fiscal policy from government and political manipulation in implementation of these policies. One of the key axioms in microeconomics is a high growth rate that is sustained in the nation’s money stock, which is in line with the excess production of goods and services. However, in such a case there is a production of high rising inflation rates. Such axioms were framed by economist such as Milton Friedman who stated that price rise is at all times and ubiquitously a fiscal phenomena. Taking account of the past record there are several countries that practices this axiom principles. Zimbabwe For example, with an annual inflation rate raised up to 89.7 sextillion percent in 2008 from 24,411% in the year 2007 (Clarida, 1999 ). As analyzed earlier in this paper the government’s willingness of forcing their central banks to have excess money printed or strategies practiced aimed at increasing the rate of inflation has been termed as inflation bias. It can also be framed as a discretionary monetary policy making process (Barro, and Gordon. 1983 p 28). However, many governments have given the central banks authority and liberty as a positive way of reducing this bias. This raises the question whether these countries with central banks independent has lowered rates of inflation. In order to come up with answers of this question it is important to analyze specific countries central bank measures in terms of independence. There are many measures that have been constructed by central banks and which are based from a variety of indicators. It is clear from research that developed countries whose central banks have high levels of independence have experienced lowered levels of inflation from the year 1955- 1988 Figure 1 Source. International Monetary Fund Recently, global inflation rate has lowered significantly since the mid 1990’s. Although it’s suggested that the central bank independent is a key player in lowering the rate of inflation, it is clear that primarily emerging markets and from developing countries has a role in ensuring that developed countries inflation rates s remains low (Calvo, 1978 p 28). In the early 1990’s many developed countries experienced a decline in the inflation rate which was a clear indication of critical focus to price constancy or fiscal policies that are well catered analyze. However, there were higher productivity growth rates, which force an increase in globalization accelerating competition levels and improving labor suppleness together with market products. According to summers and Alesina, increase in central bank liberty is among the major factors that lead to the inflation decline worldwide. The following table clearly shows there has been a marked increase in the independent of central banks between 1980-89 and 2003. Table: 1 Procedures and Distribution Rate of Central Bank liberty in industrialized countries. Advanced Economies Emerging & Developing Economies 1980 to 89 2003 Net change 1980 to 89 2003 Net change Low Independence 13 8 -5 32 6 -26 Fair Independence 8 5 -3 19 49 30 well-built Independence 0 13 13 0 15 15 However although these changes took place in the developed countries it was primarily on the emerging markets among the developing countries. It is essentially notable that liberty in many of these central banks reforms tool place in 1990’s in retort to high inflation levels (Calvo, 1978 p 58). Therefore, it is very clear that the positive movement towards increased central bank liberty unquestionably eases the task of clarifying the blunt growing inflation rate in a number of countries in the recent years. This as shown in the following figure Figure: 2 Source; commons.wikimedia.org (Alisna and summers, file) There is also an increased rate of CBI in the developed countries. However the increased rate of independent moved from weak and moderate independence to strong independence mainly because these countries joined the European Union, becoming members of European Central Bank (ECB). The ECB is expected to have strong independence as a result of the Maastricht Treaty. In comparison to the central bank independent the US inflation rate as dragged when CBI measures has been taken. However, central bank liberty implies to be of a great significance to when it comes to lowering and explanation of the spiky fall in inflation level from 1980s especially to those markets that are upcoming and growing economies. The figure below is clearly indicating that UK CB independence is lower compared to US.it shows the relationship that exists between the intensity of central bank’s liberty and the level that the prices rises in developed countries. Figure: 3 Source: bilbo.economicoutlook.net  The figure shows that countries such as UK has a low central bank freedom compared to a reduced inflation rate. On the other hand, United States independence level is the same with the UK’s, however it has a higher inflation rate again compared to UK’s (Calvo, 1978). This figure indicates that central bank independence is the key determinant of low inflation rate because as it can be seen a country may have a high central bank independence, and have a high inflation rate. Empirical Evidence The average inflation performance has a negative correlation to the sovereign of the central bank. It is note able that this correlation is not influenced by political influence in a country. However, there is a close correlation on the bank turnovers with an increased rate of inflation (Barro, and Gordon. 1983 p 289). Basing evidence on the increased rate of inflation from1970’s for example, England bank fate in 1997 was as a result of the independence reforms that were made and enjoyed by Bundesbank which could be connected with the annual reduction fall in normal inflation level of 4%. Although this freedom results into reduced inflation this rate of liberty would receive high weakness if it results into greater real economic instability. According to research it is also clear that countries that enjoys reduced rate of inflation has no cost suffering in terms of terms of more impulsive actual economic activity. Independence Meaning There is complex association between a certain central bank and the government. For example, the role of the government in dismissing CBI governing committee , the liability extent of the central bank in respect to budgetary management, its lending capability, and if there exist clear definition of strategies and goals inside the bank. The major dimension in this independence falls under the insulation that the central bank gets as a result of political pressure. The other dimension is the factor that allows the bank to liberally employ a strategy in the hunt of fiscal policy objectives (Blinder, 1998). However, this independence terminology is based on Debelle and Fischer (1994) who referred to it as “instrument freedom. The ambition freedom aspect is the bank’s capability to decide on the policy objectives without any fiscal plan interference. For example, in the UK, the England bank lacks this independence goal and as a result, the inflation goal is left as the government decision. On the other hand, in the US legal chatter sets the Federal Reserve goals. The figure below shows the inflation rate between 2008 and 2010. Figure: 4 Source: ftalphaville.ft.com  Theoretical models of central bank independence There are theoretical methods that have been used in representing the Central bank liberty. This can be attributed to the respect or weight that has been given to the inflation objectives. A roggof can be used to refer to the central bank when its inflation weight exceeds that of the government (Issing, 1999 p 24). This form of conservatism is as a result of the reality that banks are more concerned in maintaining a reduced as well as an inflation rate that is stable. As a result of the fact that central banks main objective is attaining its inflation goal, there is a higher marginal cost in inflation than that in the government. The problem in using the rogoof model to interpret the central bank independence is that they imply a conservative central bank (Issing, 1999 p 64). Another way or model for this independence interpretation is viewing the central bank in the context of having its own objectives although the government objectives have to be considered by the bank when deciding on its objectives. When the government has a lower interest on the desired inflation than the government, there would be consistency in the economy’s natural rate of output (Barro, and Gordon. 1983 p 253). However, once there is a set policy aimed at maximizing the bank subjective average weight as well as the objectives of the government. This comparative influence on the banks objectives gives in a bank’s freedom measure. However, when there is complete weight there is no weight that is contained in the objectives of the government. Again if there is the difference in the desired inflation target between the goals of the central bank and those belonging to the government then the central bank intensity sovereignty affects the standard inflation and not the instability of each production or inflation. Conclusion In this research, it is clear that many countries have given their central bank’s independence although this idea is facing a lot of critics. Most of these critics have been based on banks accountability once they are fully independent (Barro, and Gordon. 1983 p 23). Although, having a stable and reduced inflation level is a key communal goal it relics and not the only macroeconomic objective. In such a case, monetary policy has an end effect on the actual monetary variables, which can also have effects on the financial system in the long run. Accountability is a key factor and undertaking some policies like central bank’s freedom requires some special mechanism’s result, central banks have receive an instrument independence due to a number of reforms. This has took place while there is high preservation of the countries government in setting goals and plans as well as assessing the performance of the central bank as far as achieving inflation goals is concerned. Reference list Inflation, Barro, R. J. a. D. B. G., 1983. A Positive Theory of Monetary Policy in a Natural Rate Model.. Journal of Political Economy , pp. Vol 91, p 589-610.. Blinder, A. S., 1998. Central Banking in Theory and Practice. 1 ed. Cambridge: The MIT. Calvo, G., 1978. On the Time Consistency of Optimal Policy in a Monetary Economy.. 2 ed. New York: the MIT. Clarida, R. J. G. a. M. G., 1999. . The Science of Monetary Policy: A New Keynesian. a journal for economic literature, Volume 37, pp. 1661-1707. Ireland, P. N., 1999. Does the Time-Consistency Problem Explain the Behavior of Inßation. journal for monetary economy, Volume 44, pp. 279-91. Issing, O., 1999. The Eurosystem: Transparent and Accountable or ‘Willem in Euroland.’. journal of common market studies, Volume 37, pp. 503-519. Read More