Fischer 1995

Central-Bank Independence (CBI) Revisited

Introduction

• CBI is supported by empirical evidence, economic theory, and the current economic climate.

• Goal: Define CBI that improves economic performance and address remaining issues.

Theoretical Basis for Central-Bank Independence

• CBI addresses inflationary bias in monetary policy.

• Inflationary bias is attributed to dynamic inconsistency and revenue motives.

• Two main approaches:

  • Conservative-central-banker approach (Rogoff):

  • Central bank focuses on minimizing deviations from optimal output and inflation.

  • Entrusting policy to a conservative central banker leads to lower, more stable inflation but potentially more variable output.

  • Principal-agent approach (Walsh, Persson, and Tabellini):

  • Contracts impose costs on the central banker for inflation deviations.

  • Inflation penalty is linear and easy to design.

Realism of the Approaches

• Conservative central bankers consider both inflation and output trade-offs.

• Principal-agent approach is used in New Zealand, Canada, and the UK, where inflation targets are agreed upon with the government.

### Goal Independence vs. Instrument Independence

Instrument independence: Control over policy tools.

Goal independence: Setting own policy goals.

• Rogoff approach: Central banker has both goal and instrument independence.

• Principal-agent approach: Central banker has instrument independence but not goal independence.

Key Conclusions

• Central bank should have instrument independence but not goal independence.

• Clearly defined goals and the power to achieve them are essential.

• Accountability is needed for incentives and democratic oversight.

• Accountability forms vary by country.

• Instrument independence means freedom from financing government deficits and the power to set interest rates.

• The role of central banks in supervising banks is still debated.

• Government typically controls the exchange-rate system.

Inflation-Targeting

• CBI increasingly involves setting inflation targets.

• Targets are typically for a range over one to two years or a path over several years.

• Issues in choosing an inflation target include:

  • Whether to target variables directly controllable by the central bank.

  • Whether to use an exchange-rate peg instead.

  • Why inflation should be the sole target.

  • Whether to specify a nominal income target.

  • Whether to target a price level instead of an inflation rate.

• Best practice: target a policy variable directly controlled that closely controls inflation or output.

• Monetary targeting is unreliable due to the breakdown in the relationship between money growth and inflation.

• Nominal-exchange-rate pegs can anchor monetary policy and expectations, especially in stabilizing from high inflation or in small, open economies.

• The choice between an exchange-rate peg and an inflation target depends on the economy's history and structure.

• Inflation is a monetary phenomenon, but monetary policy affects both output and inflation in the short run.

• Nominal-income-targeting trades off real income and inflation one-for-one.

• Difficulties with nominal-income-targeting include data lags and lack of public interest.

• Inflation-targeting benefits include direct concern to economic agents and easier monitoring.

• Inflation-targeting is preferable to nominal-income-targeting if adjusted for supply shocks.

• Price-level-targeting requires offsetting past inflationary shocks, leading to short-term fluctuations.

• Inflation-targeting is preferable to price-level targeting because most nominal contracts are short-term, and monetary policy would be more demanding.

Open Issues

• The negative relationship between legal independence and average inflation may not be causal.

• In developing countries, the basic negative relationship between legal independence and average inflation does not hold.

• CBI in industrialized countries appears to have no costs in terms of growth.

• Possible explanations:

  • More-independent central banks are better at stabilization.

  • Fiscal policy is more disciplined in countries with more CBI.

  • Performance is primarily affected by shocks.

• The political system should shield monetary but not fiscal policy from political pressures.

• A central bank can be too independent, potentially missing benefits from coordinating monetary and fiscal policy.

• Central-bank accountability is essential to shield policy from inappropriate pressures and be sensitive to public needs.