Essay on "Does Central Bank Independence in Transition Economies Bring Lower Inflation?"

Essay 6 pages (2063 words) Sources: 5

[EXCERPT] . . . .

Central Bank Independence in Transition Economies Bring Lower Inflation?

Inflation is simply a situation where too much money chases too few goods, as per the macroeconomic definition. In the developing society inflation can be a political and economic question and price rises may make the government unpopular. Other fiscal measures like taxes, war and global occurrences can trigger inflationary tendencies. In most countries the Central banks are vested with the authority to deal with the prevailing economic needs, ad follow their own monetary policies which then become the monetary policies of the state. Is this independence given to the Central Bank a factor in containing inflation? To answer that question it has to be borne in mind that the Central Bank is the banker to the nation, and primarily deals with banking policies, which also includes the interest rates, lending rates and creating or suppressing liquidity in the economy.

Role of Central Banks

There are fiscal duties of the bank as being the Bankers banker and also the custodian of the currency -- which is minted and circulated as per the banks perception of the need for liquidity. In most cases Central banks have also duties that may be termed quazi fiscal. These activities and regulations have a great impact on the economy. (Munoz, 2007, p. 3) in Asia the economy differs from country to country. Thus the role of the central bank also differs. For example Hong Kong has no central bank, and for Singapore the government itself acts as the banker for the country. For Taiwan and Korea both have central banks yet the financial policies are not as sound as in Hong Kong or Singapore both of which nations are far ahead in terms of stability and growth. Thus a central bank with government intervention will not be successful in the objectives. (Salvatore, 1991, p. 8) Thus where the bank exists as an institution what is to be observed is if its autonomy gives greater control of inflation. That brings up the question of the importance of autonomy to the bank.

Government and Bank Autonomy

The government is largely controlled by political parties and therefore there is always an element of popular feeling that has to be taken into account before economic actions are initiated. Politicians are influenced by electoral considerations. Thus the short-run electoral considerations may overawe the policies for longer-run inflationary trends and this may make the central bank accede to populist policies that may in the long run make high. Thus the effectiveness of the bank policies is always based on the relationship between central bank and governments. The greater degree of independence of the bank has in researches shown that there is no direct correlation between the freedom enjoyed by the Bank and the inflation rate. Likewise the same research showed that the actions of the Central Bank and the inflation rates have not shown any direct correlation. In most countries the significant effect of the policies has a 20% effect on the economy of most countries. Thus while the actions of the Central Bank does play a role in inflation management; it is not the unique and central factor that determined the success of the policies. (Klomp; de Haan, 2010, p. 445)

In the case where the bank is fully autonomous, the policies of the bank at times may clash with the populist requirement of the government. While the Central Bank may be in the thick of inflation targeting for a country, the political consensus or political will is also a necessary part. Thus there is no absolute autonomy to the bank in the matter but it has to at all time act only in unison with the politicians and those in power -- the elected government. This is because the implementation of the schemes evolved by the central bank can be done only through the government -- including regulations on interest and lending and general monetary policy. Under these circumstances it can be shown that the central bank per se cannot by its actions control or regulate any economic force except with the consent and cooperation of the government and the policies of the ruling ministry. (Heenan; Peter; Roger, 2006, p. 6)

However the government and the concerned ministries- for example the finance ministry that sees to budgets and planning, and the commerce ministries would not be able to function and plan but for the regulations and cooperation of the central bank which must be able to control the money flow and liquidity. Why do some governments deny more freedom to the Central Bank? The governments hesitate to give complete autonomy because the activities of the central bank creates volatility in the market-especially the financial market and this affects all markets and inflation targeting thus is based on the monetary policy of the central bank. (Bernanke; Laubach; Mishkin, 2001, p. 22) Thus the disciplining and control of the central bank is also a part of general governance.

In most countries where the central bank plays an active role in controlling the economy the government and the bank create a joint target of inflation. The targets are at times created by the government -- the inflation rate. However in most Asian countries and even in Israel the dictated rate of the government is advised upon by the Central Bank. In some countries as Britain, Brazil and Israel the government sets the inflation rate that is to be achieved -- that is lowering inflation to the level. In most other countries it is the Central bank that announce the inflation rate targets they set for all the other mechanisms of the economy and which the central bank seeks to achieve with a series of economic measures. In a depression the Central bank tries to achieve a targeted inflation rate to support the economy and vice versa. (Schaechter; Stone; Zelmer, 2000, p. 6) Thus there is either a quasi- independent structure or relation between the government and the bank or an absolute independence for the Bank.

Independence and Inflation:

Where the bank has full autonomy, the monetary policies are in its expert realm. Monetary policy is the prime responsibility of any government, and the policy is made in consultation with the central bank. The European Central Bank, in hypothesis for example has price stability as its main reason d' entree where the banks have autonomy they have a greater impact on the fiscal policies and thus the inflate targets. (Bernanke; Laubach; Mishkin, 2001, p. 23)

One question that has to be answered is how far the independence of the Bank relates to the price stability? In most countries over time the fiscal policy and the external conditionality imposed by the bank and is one of the components. However it doers not become a sin qua non-for the control of inflation. (Maliszewski, W.S. 2000, p. 751) it is possible to achieve the effect by direct government and other agency actions. But the Central Banks actions have been observed to have a direct impact on prices in the developing countries. In most countries Inflation controls and measures thus are set by the central bank and the finance ministries and other concerned departments. The inflation rate planning also is a factor that largely influences the government budgeting and planning in other are4as. Therefore the central bank while playing the major role in dealing with the economy and macroeconomic variables, also plays a role in the government's perception of its plans, functions and budgets. (Heenan; Peter; Roger, 2006, p. 7)

Developing Countries:

It was observed that in the case of most African countries monetary policy to curb inflation either is absent or neutral or is based on a tightening of cash flow and this was observed for Nigeria where the central bank by increasing foreign exchange holdings and in Ghana and Mozambique in 2008 steps in tightening currency by resetting the prime lending rates to 17% has had its effects. (United Nations, 2009, p. 113) Central banks in developing nations have also played a key role in using fiscal policies in combating unsettling economic forces like inflation. However the impact of the banks actions in developing countries has not yet been conclusive according to the IMF it was acknowledged that inflation control for the developed nations could be verified with the inflation targeting methods, but such data is not much in evidence for the developing countries. (Jacome; Vazquez, 2005, p. 8)

Many researches have been undertaken in this context. One fact from the experience of the developed countries becomes clear. The Central Bank must for all nations have some autonomy as the Judiciary of a country in respect of economic review and legislations. In the research where the De Facto JI and central bank turnover indices, were compared for judicial and Central Banking autonomy it was found that a significant coefficient of correlation showed that where the independence of the Bank was at par with the Judiciary, there was more effect in its actions towards inflation.… READ MORE

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