Central Bank Independence FNCE 4070 – Financial Markets and Institutions

General Definitions Instrument Independence – This is the ability of the central bank to set monetary policy instruments. Goal Independence – This is the ability of a central bank to set the goals of monetary policy

ECB Definitions Functional independence. This is the same as instrument independence. It is all about having the tools to carry out monetary policy and being free to use them as seen fit. Institutional Independence. This is a strict prohibition on allowing governments to try to influence monetary policy. Personal independence – The ECB is designed to make sure that individuals on the governing council of the ECB have sufficient tenure to be able to not be subject to political pressure. They have minimum terms of 5 years. Financial Independence – the goal here is to make sure that the central bank has sufficient financial resources to fulfill their mandate. In addition not to have its resources subject to political pressure.

The Case for Independence Subjecting the Fed to more political pressure would impart an inflationary bias to monetary policy. Politicians are short-sighted because they are driven by their need to win the next election. – Thus they will seek short-run solutions to problems, such as high unemployment and high interest rates, even if the short-run solutions have undesirable long-run consequences. – This would create a political business cycle, in which just before an election, expansionary policies are pursued to lower unemployment and interest rates. The control of monetary policy is too important to leave to politicians, a group that has repeatedly demonstrated a lack of expertise at making hard decisions on issues of great economic importance, such as reducing the budget deficit or reforming the banking system.

The Case against Independence It is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. – The current lack of accountability of the Fed has serious consequences: If the Fed performs badly, there is no provision for replacing members. – If you push the argument further where do you end? Certainly there would be a similar argument to be made about fiscal policy, military budgets etc… An independent Fed has not always used its freedom successfully. – The Fed failed miserably in its stated role as lender of last resort during the Great Depression. – Its independence didn’t prevent it from pursuing an overly expansionary monetary policy in the 1960’s and 1970’s that contributed to rapid inflation.

Episode of Disinflation around the world Year Country Germany United States United Kingdom