Central Bank Independence And Low Inflation example essay topic

AFEAEM 734 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". (web). This can also be supported by Ismihan and Ozkan (2003, p 2) 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. (web).

This goes against the view of the governor of the South African Reserve Bank (S ARB) 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". (web). 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, P 154) 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 p 22) 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, P 153) 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 later in the assignment, in the example of New Zealand, the above are key essentials for an independent central bank to be successful in its quest to lower inflation.

More emphasis is placed on the political independence of a bank mainly because of the central banks relationship with politics regarding who sets the objective and who is responsible for the means of attaining that objective. Lougani and Sheets (1997 P 382) uses Grill i, Masciandaro and Ta bellini (GMT) measure of factors that determine whether a bank is politically independent or not. These include the procedures for appointing the central bank's chairman and board members, the term of office of central bank officials and whether the central bank objective of price stability is explicitly stated in the central bank charter. As the above states, there is a clear path of what is required for an independent central bank to be successful in lowering inflation. Further on in their investigation Sheets and Lougani (1997, p 383) use Cukierman (1992) ideas the characteristics of legal CBI can be divided into four major components. The first relates to the appointment, term and dismissal of the governor and other members.

The second considers political independence - whether the bank is free to conduct monetary without the interference from the government. The third accounts for the degree of importance the objective of price stability is to the central bank. The final component looks into the limitations on central bank lending. Cukierman also goes onto to look at actual independence, which the rate of turnover of central bank governors is used as a measure. In summary a lower rate of turnover indicates that the central bank is more insulated from the political pressures, suggesting greater freedom to press home their goal for price stability. There are several ways that can be utilised to reduce the level of inflation.

These can range from money supply targeting, interest rate targeting to inflation targeting. Andreas Fischer (1993 Pg 5) commented on Milton Friedman's idea of the Constant Money Growth Rule. The economist argues that this theory is relevant because of long and variable lags in monetary policy (time inconsistency). However the theory has been empirically scrapped due to the reasons that financial innovation has made narrow money subject to unstable velocity making it an unreliable factor regarding inflation. Another method that independent central banks, again mentioned by Fischer (Pg 6) is targeting a nominal exchange rate to a low inflation country. However evidence from the Exchange Rate Mechanism shows that countries that have gone in with high inflation rates have seen their unemployment levels rise also. e.g. ebo and Englander (1992) say in the United Kingdom for example, there is no evidence that there is a downward shift in inflation and therefore the ERM alters the trade-off between inflation and unemployment.

A successful policy that has been used in New Zealand is inflation targeting. Inflation targeting according to Bernanke et al is where "a framework for monetary policy characterised by the public announcement of quantitative targets for the inflation rate over one or more time horizons and by explicit nature that low, stable inflation is monetary policy's primary long-run goal". (web). There are several reasons why banks utilise inflation targeting to lower inflation. One of the reasons include a desire to give the central bank instrument independence - which I touched upon before - but to balance that with a clearer specification of what the central bank should achieve with the instrument independence. (web). There are obviously some problems with inflation targeting. This can be linked in with the inflationary bias / time inconsistency problem and the trade-offs between inflation and economic variables.

For example there is a negative trade-off between the variability of GDP and the variability of inflation and there is a tendency for politicians and policy makers to exploit this trade-off by lifting the rate of inflation to push the economy to run faster than its capacity limits allow. This problem is known as the inflationary bias. According to Fraser (Pg 2), cynics blame the inflation bias on the political process, claiming that politicians have short time horizons stretching as far as the next election for example. Regarding an independent central bank and price stability, raising the level of goal, political, economic and instrumental independence afar from all political pressures can solve inflationary bias.

The trade-off between inflation and growth is negatively correlated. In my example of New Zealand, Hutchison and Walsh (1998) produced a report analyzing the effect of this trade-off on the central bank reform and used New Zealand as an example. Since the Reserve Bank of New Zealand had been given independence in 1989, Hutchison and Walsh in their conclusion found that prior to 1989 the trade-off was stable. However post-1989 has shown that the trade-off started to rise mainly due to the central bank reform. (Pg 18) quotes that "low expected inflation and low average inflation are associated with high short-run trade offs". The graph shows the output-inflation trade-off with response to inflation in New Zealand.

The following graph shows actual inflation rates and shows that there is a negative output-inflation trade-off. This also means that the sacrifice ratio - the unemployment cost of reducing inflation - is larger; when changes in output lead to only small movements in inflation, a large economic downturn is needed to reduce inflation levels. Debelle (1994) found that the sacrifice ratio for New Zealand rose from 1.3 in the 1980-1984 disinflation to 2.8 in the 1989-1992 disinflation. Some explanations have been sought to account for the change in the trade-off. Hutchison and Walsh (1998) use the idea of credibility - more credible central banks can lower the rate of inflation through publicly announced goals with smaller consequences for unemployment.

The more credible a bank is the immediate effect that the announcement is going to have on inflation. However the credible hypothesis goes against the work carried out by Hutchison and Walsh. There are other trade-offs that inflation has with economic variables. For example Dolmas, Huffman and Wynne (1998) found that there is a positive correlation between inequality and inflation. They conclude that democracies with more independent central banks tend to have better inflation outcomes for a given degree of inequality. Another trade-off exists between inflation and unemployment.

Policy makers can again use the inflationary bias theory to take advantage of this trade off bringing us back again to the subject of who has the role of setting the objective of price stability. The next part of this assignment looks at New Zealand as an example of how successful the Reserve Bank of New Zealand has been in keeping inflation at a low level. The Reserve Bank of New Zealand was granted independence in 1989 and in addition was given the sole responsibility of low inflation. The Bank used inflation targeting as a means of improving inflation performance and immediately came up with an explicit target for inflation. According to (web) price stability is defined by the legislative act as the sole objective of monetary policy. The actual implementation of policy is guided by the Policy Targets Agreement (PTA) between the Minister of Finance and the Governor of the Bank.

"A mechanism for holding the Reserve Bank Governor accountable was written into the Act by (1) making the Governor directly responsible for the conduct of monetary policy, and (2) allowing for the Governor's dismissal if the goals established in the PTA are not met". The PTA's have defined the target to be 0-2% inflation as measured by the Consumer Price Index. Since then on the 10th December 1996 the Reserve Bank of New Zealand (PTA) had been amended to set a new explicit inflation target of 0-3%. The PTA also made it explicit that price stability is a means to an end, its value being enhanced sustainable economic performance. (web). The structure above is clear and clearly shows that the Bank has responsibility for the inflation rate for New Zealand. Why was this reform needed?

Well between 1973 and 1985 average inflation rate in New Zealand was 12% compared to the 7% rate in the U.S. In between 1986 and 1992 average New Zealand inflation rate was 6.9% compared with the U.S. average inflation rate of 3.8%. (web). The next question posed is has inflation targeting helped New Zealand lower the level of inflation to the PTA's designated requirement. Well a speech by Brash who is the Governor of the Reserve Bank of New Zealand seems to think so. In his speech on 5 January 2002 to be found at (web) he comments that he has no doubt that the process of inflation targeting has provided a nominal anchor for monetary policy. (Pg 2) Brash goes on to say that "Inflation targeting helped us to achieve a substantial improvement in our inflation performance in real terms; it helped us to reduce inflation relative to inflation in other developed countries; it helped us reduce the volatility of inflation and it helped us maintain that inflation performance. The graph below from Fischer, A. (1993 P 23) shows the actual and expected inflation change for New Zealand.

The graph shows that actual inflation pre reform in 1989 was volatile. When the bank was made independent in 1989 the aftermath effects on inflation mirror the statement made by Brash I quoted above. Another graph below again available from Fischer (Pg 15) reiterates the inflation performance in New Zealand. The graph above supports the hypothesis that there is a negative correlation between the degree of central bank independence and inflation.

The graph below available from (web) compares inflation performance in New Zealand with that of the average inflation rate of 19 OECD countries. The following graph from (web) analyses the relationship between inflation and economic growth. Fuhrer (Pg 28) asks the question do countries such as New Zealand with a high degree of central bank independence and low inflation pay for it with high unemployment, slower growth and higher variability of growth? Well I refer back to work carried out by Hutchison and Walsh earlier in the assignment that found out that the output-inflation trade off had increased post-1989 and Debelle (1994) found that the sacrifice ratio has risen to 2.8 from 1.3 in 1989-1992. This supports the confession made by Brash in his statement that "Output volatility was higher in New Zealand during the nineties then say Australia or the United States".

Conclusion The conclusion regards the hypothesis stated in the introduction that there exists an negative correlation between the degree of central bank independence and low inflation. There have been many empirical research reports investigating the role of the central bank and have all come to one basic conclusion that there is a negative correlation in place. In the case of New Zealand, central bank independence in 1989 for the Bank helped set up a Policy Trade Agreement 0-2%. This explicit target helped lower average inflation from 12% between 1973 and 1985 to 2% in 1998. This supports the negative correlation graphs I used from Alesina and Summers where New Zealand is one of the countries used to explain the inverse relationship.

However this is just one example. As Ismihan and Ozkan have commented empirical evidence for the negative correlation in developing countries has been less clear-cut. However I believe you need to look deeper than just the independence of the central bank to answer the question of low inflation. I have found out from New Zealand that the output-inflation trade-off is considerably higher after central bank independence. Hutchison and Walsh (1995) found that low expected inflation and low average inflation are associated with high short-run trade offs. In addition to this the sacrifice ratio has risen from 1.3 to 2.8 post 1989.

This begs the question at what sacrifice does central bank independence and low inflation come at? Another factor that must be looked at is the level of political pressure that an independent central bank faces when facing the inflationary bias that inevitably occurs from trade-offs such as output and inflation. The general consensus according to Cukierman, the more politically independent an independent a central bank the lower the inflation. However the problem of inflationary bias is still apparent in politically run central banks. In summary to this conclusion, with reference to New Zealand, the higher the degree of central bank independence the lower the average inflation.

However this correlation is only rather specific to individual countries where the information can be available to either disprove or prove that the hypothesis is correct. In developing countries there are other measures that can be utilised to lower inflation, which may not therefore include the strategy of CBI, therefore the hypothesis is only relevant to certain countries. AFEAEM 734 Macroeconomics for Banking and Finance Coursework

Bibliography

1. Alesina, A & Summers, L.H. (May 1993), "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence", ' Journal of Money, Credit and Banking', Ohio, Vol 25, No.
2, PP. 152-162.2. Dolmas, J, Huffman, G.W. & Wynne, M.A. (Feb 2000), "Inequality, Inflation and Central Bank Independence", ' Canadian Journal of Economics', Canada, Vol 33, No.
1, PP. 272-286.3. Fischer, A.M. (Spring / Summer 1993), "Inflation Targeting, The New Zealand and Canadian cases", ' Cato Journal', Vol 13, No.
1, PP. 1-29.4. Fischer, S. (Dec 1996), "Central Banking The Challenges Ahead: Maintaining Price Stability", ' Finance and Development', PP.
1-7.5. Fraser, B.W. (Dec 1994), "Central Bank Independence, What does it mean?" , 'Reserve Bank of Australia Bulletin', PP.
1-8.6. Fuhrer, J.C. (Jan / Feb 1997), "Central Bank Independence and Inflation targeting: Monetary policy paradigms for the next millennium", 'New England Economic Review'.
PP. 1-36.7. Hutchison, M.M. & Walsh, C.E. (1998), "The Output-Inflation Trade Off and Central Bank Reform;
Evidence from New Zealand", 'The Economic Journal', PP. 703-725.8. Ismihan, M. & Ozkan, F.B. (July 2003), "Does Central Bank Independence Lower Inflation?" , University of York, PP.
1-9.9. Lougani, P & Sheets, N. (Aug 1997), "Central Bank Independence, Inflation and Growth in Transition Economies", 'Journal of Money, Credit and Banking' Vol 29, No.