The Rol of Central Bank Independence

AFEAEM734 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”. (www.worldbank.org/html/dec/Publications/Bulletins/PRBvol3no5.html).

This can also be supported by Ismihan and Ozkan (2003, p2) 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. (www.worldbank.org/fandd/english/1296/articles/0101296). This goes against the view of the governor of the South African Reserve Bank (SARB) Tito Mboweni who argues that the link between CBI, inflation and long-term growth is a positive one.