The aims of central bank independence

The aims of central bank
independence
The aim is to insulate monetary policy from political interference and from
electoral pressure to deliver short-term economic growth at the expense of longerterm inflationary cost. Independence from the fiscal authority is particularly
important as a protection against monetization of debt. A credible government
commitment to central bank independence is deemed to lower the cost of reducing
inflation, because it is not necessary to raise interest rates so much.
There are two main models: “goal” and “operational” independence. In the former,
the bank has the power to set the objectives of monetary policy, such as price
stability along with an inflation target. The supreme example is the European
Central Bank, whose independence is enshrined in treaty.
At the other end of the spectrum is the Bank of England. Its monetary target is set
by the chancellor of the exchequer, and it is accountable to both the executive and
legislature. Governments can exert pressure through appointments to the bank.
These attempts to achieve the discipline of the gold standard by other means have
in recent years staved off inflation but failed to prevent extreme financial
instability. That, along with the central banks’ encroachment on fiscal policy
through measures such as quantitative easing, has brought independence under
attack from financial conservatives.
Accountability is also becoming a more pressing issue, not least in Japan. Nobuyuki
Nakahara, a former member of the Bank of Japan’s monetary policy board, says:

“In Japan, there are two governments: one, the central government; the other, the
Bank of Japan, with no democratic legitimacy.”
Central banks should be in a position to decide the timing and pace of the inevitable
normalisation without being unduly constrained by these pressures. What is ultimately at
stake is their credibility in fulfilling their mandates.

Central Bank Independence
A Federal Reserve that is insulated from short-term political pressures but accountable to public
concerns is more likely to pursue policies that align with its congressional mandate to promote stable prices,
full employment, and moderate long-term interest rates. Introduction

The Federal Reserve has a number of responsibilities, but its most visible role is the formulation of
monetary policy. While the Federal Reserve's Board of Governors is appointed by the President
and approved by the Senate, and the chairman of the Board reports to Congress bi-annually, the
Fed conducts monetary policy without further legislative or executive branch involvement. A
consensus has evolved among economists that a politically insulated Fed is more likely to pursue
policies that align with its congressional mandate, last revised in 1977, to promote the goals of
moderate long-term interest rates, maximum employment, and stable prices.
Elected governments in a democratic society potentially face incentives to pursue accommodative
monetary policies that promote output and employment for political gain in the short run, even

when those policies would eventually lead to inflation. Independent central banks can better
maintain credibility for consistently pursuing price-level stability than those that do not enjoy
independence. That independence is necessarily limited, however, as a central bank serves a
public purpose and must be accountable to the government.
Economic Arguments for Independence
The arguments in favor of independence derive from a central bank's monopoly over money
creation. This monopoly carries with it certain powers that elected governments may be tempted
to misuse for short-term benefits at the cost of rising inflation over time. Resisting such
temptations requires a degree of commitment on the part of the central bank, and without
independence, that commitment might be difficult to maintain.
Two broad incentives might lead a government-controlled central bank to abuse its moneycreation powers. First, money creation that leads to unexpected inflation reduces the real value of
nominal liabilities, such as interest-bearing debt. In turn, this relieves the government of the need
to increase taxes or reduce spending to balance its budget. Second, a surprise monetary
expansion can increase output and employment in the short run, permitting governments to
engineer expansions in an effort to increase their popularity.
The temptation for governments to use money creation to inflate away the real value of nominal
liabilities has been studied by Columbia University economist Guillermo Calvo ( Calvo 1978
) and University of Chicago economists Robert Lucas and Nancy Stokey ( Lucas and
Stokey 1983

), among others. For instance, take a case of extreme lack of policy

commitment in which decisions are made with no regard for past promises. If there is nominal debt
outstanding, then ignoring the costs of inflation, the government might choose to produce a
monetary expansion large enough to eliminate or greatly reduce the real debt. Over time, though,
the public would come to expect such behavior and this would result in ever-higher inflation and
nominal interest rates.
This vicious cycle can be forestalled only through a commitment to future low-inflation policies. An
independent central bank helps to provide such commitment because the formation of monetary
policy occurs outside the day-to-day demands of government finance and the sphere of political
influence.
University of California, Santa Barbara economist Finn Kydland and Arizona State University
economist Edward C. Prescott (Kydland and Prescott 1977
), as well as Harvard University
economist Robert Barro and Clemson University economist David Gordon ( Barro and Gordon 1983
have studied the interaction between lack of policy commitment and inflation. In their
analyses, monetary policy can affect the real economy only through expansions that come as a
surprise to the public. These expansions are tempting to pursue if there are inefficiencies in the
economy that make real activity undesirably low. For example, labor or product markets may not

be perfectly competitive, and some wages and prices may be inflexible.
If monetary policy is controlled by a government that cannot commit to its future policy behavior,
then such surprise expansions would result in a high inflation rate but no benefit in terms of real
activity — over time the public would no longer be surprised by the monetary expansions. But if
monetary policy is conducted under commitment, the economy can benefit from lower inflation

with the same level of real activity (Wolman 2001). Insulating the central bank from short-term
political pressures can facilitate such commitment.

Independence in japan
The new government in Tokyo wants to see more aggression from the Bank of Japan.
The monetary prong of its legislative program calls for a higher inflation target and also an open-ended
commitment on the part of the BOJ to expand its balance sheet.
It will get its way too, as perhaps a democratically-elected government should. Indeed, it has threatened
to strongarm the BOJ with legislation but may not have to go so far. The current BOJ governor, Masaaki
Shirakawa, will come to the end of his term in April. It will probably be far easier to appoint an
independent successor who will decide, independently, to deliver what the politicians want.
So, is central bank independence more broadly just another pillar of pre-crisis finance destined to topple
in our post-crisis world?
The argument in its favor is well known and essentially runs like this: if you give the politicians (even if you

voted for them) the monetary reins, they just won't be able to help themselves. As surely as rivers run to
the sea, the scoundrels will pursue the election-winning goal of short-term employment with excessively
expansive policy. They'll buy today's boom with tomorrow's bust and hope tomorrow will be some other
politician's problem.
No, no, much better that a sober, independent central bank rises above narrow political concerns and
pursues a longer-term policy, with the predictability bond markets like as an added bonus.
That's the theory. The practise was rather different. Independent central bank policy may not have stoked
the sort of short-term imbalances to which politicians are supposedly addicted. Instead, it stoked the longterm ones that pushed the entire financial system off the cliff.
Now, you may still think that one near-fatal central bankers' global crisis every couple of decades is better
than a succession of smaller, politicians' ones every couple of years. But even then you'd have to
concede this is hardly a black and white argument for independence.
And just look at the central banks' mandates. Of the explicit inflation targeters, the Banks of Japan and
England have missed their inflation guidance for years now. The Fed is supposed to be helping the U.S.
generate full employment and the European Central Bank is meant to be implementing monetary policy in
the best interests of the entire euro zone. Ask the Spanish or the Greeks how it's doing.
They've all missed to some degree. It's tempting to suggest that a non-independent central bank can miss
a mandate just as convincingly as an independent one.

So, in the end we are left with one basic question. For all the arguments in its favor, has independent
central banking been such a success in the recent past as to demand it remains ring fenced from such

issues as national defense, healthcare policy, education and all the other grave issues with which we
entrust our elected representatives? And the answer has got to be no.

Benefits of Central Bank Independence
by Tejvan Pettinger on January 9, 2008 in finance

Monetary Policy used to be the preserve of the Government. The Government would change interest 
rates to meet its various economic objectives. At different times the Government would give priority to:
lower inflation
higher growth
targeting exchange Rate
and even balance of payments.






For example, in the early 1980s, the Thatcher Government increased interest rates to reduce inflation.
In 1987, after a stock market crash, interest rates were cut to boost economic growth. In 1992, interest 

rates were increased to 15% to try and maintain the value of the £, which was then in the Exchange Rate 
Mechanism ERM

Arguments for Central Bank Independence
1.
2.

3.

It was argued that the governments tended to make poor decisions about monetary policy. In particular they
tended to be influenced by short term political considerations.
Before an election, the temptation is for a government to cut interest rates. This increases economic growth,
reduces unemployment and increases the political support of the party. However, this expansionary monetary policy
may lead to inflation and boom and bust economic cycles. Therefore arguably, it is better to take monetary policy
out of government’s hands.
People have more confidence in the Central Bank, therefore this helps to reduce inflationary expectations.
In turn this makes inflation easier to keep low.

Bank of England’s Independence 1997
In 1997, the Labour party gave the Bank of England full independence in setting Monetary Policy. 

However, the government did give the Bank of England an inflation target of RPI 2.5% +/­1 (now CPI 2% 
+/­1)
If the inflation rate goes outside this range the Bank of England has to write an explanatory note to the 
chancellor.
Between 1997­2007, the Central Bank did a reasonably good job in keeping inflation low, and enabling a 
long period of economic expansion. From 2007­2011, the Bank struggled with the combination of credit 
crunch, deep recession and cost push inflation.

In 2010 and 2011, the Bank had to tolerate inflation going above target (e.g. CPI inflation 5.2% in October
2011) because of the risk of pushing the economy back into a double dip recession. However, it was a 
difficult economic situation, and there were few alternatives to their policies.

Bank of England and Quantitative Easing
The 2009 recession was so serious that cutting interest rates failed to boost economic growth, therefore 
the Bank of England pursued unconventional monetary policy ofquantitative easing. This involved 
creating money and buying government bonds. The aim was to reduce interest rates and increase money




supply. It is quite controversial because
Involves creating money ‘printing money’ with risk of creating future inflation
Makes the bank more political, e.g. decision to buy government bonds arguably helps the government to
borrow more at a lower interest rate cost.
Benefits of quantitative easing mainly go to top financial firms and bankers. Only small fraction of extra
money filtered through into loans for small companies.
However, the policy helped to offset the deflationary impact of government spending cuts. It gave the UK 
greater flexibility compared to Eurozone

Independence and governance are two key terms relates to central bank.
Independence refers
to the ability of the central bank to use the instruments of monetary control without
instruction, guidance or interference from the government (Henning, 1994). On the
other
hand, according to Amtenbrink (2004), the three pillars of central bank governance
are: i).
central bank independence, ii). central bank accountability, and iii). central bank
transparency. So, it means good governance in a central bank is a function of its
independence
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Target independence
Fundamental target independence – the right to choose its own fundamental objective or
objectives – is possessed by no central bank. Even the most independent of all central banks,
the ECB, has its multiple fundamental objectives laid down in an external document – the Treaty
Establishing the European Community. Article 105 states that“The primary objective of the
ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the
ESCB shall support the general economic policies in the Community with a view to contributing
to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall
act in accordance with the principle of an open market economy with free competition, favouring
an efficient allocation of resources, and in compliance with the principles set out in Article 4.”

Article 2 of the Treaty states: “The Community shall have as its task, by establishing a common
market and an economic and monetary union and by implementing common policies or
activities referred to in Articles 3 and 4, to promote throughout the Community a harmonious,
balanced and sustainable development of economic activities, a high level of employment and
of social protection, equality between men and women, sustainable and non-inflationary growth,
a high degree of competitiveness and convergence of economic performance, a high level of

protection and improvement of the quality of the environment, the raising of the standard of
living and quality of life, and economic and social cohesion and solidarity among Member
States.”
I still think it will come as a surprise to ECB Executive Board member Jürgen Stark that one of
the objectives of the ECB is to promote equality between men and women – albeit without
prejudice to the objective of price stability.
The Bank of England’s monetary policy objectives are laid down in the Bank of England Act
1998. They are to deliver price stability and, subject to that, to support the Government’s
economic objectives including those for growth and employment.
The Fed has a triple mandate, given in Section 2a. of the Federal Reserve Act: “The Board of
Governors of the Federal Reserve System and the Federal Open Market Committee shall
maintain long run growth of the monetary and credit aggregates commensurate with the
economy’s long run potential to increase production, so as to promote effectively the goals of
maximum employment, stable prices, and moderate long-term interest rates”.
Of all leading central banks, only the ECB sets its own quantitative operational targets. It
defines price stability is an annual rate of inflation (measured by the HICP index) below but
close to two percent. The Bank of England’s operational is set by the Chancellor of the
Exchequer. It is currently a two percent annual inflation rate for the HICP (known in the UK as
the CPI). The Fed has no quantitative target for any of its three fundamental objectives. Under
Chairman Ben Bernanke, it has been edging slowly towards an implicit inflation target, captured
by the average or median 3-years ahead inflation forecasts of the members of the FOMC.
Whether this implicit inflation target is defined in terms of the CPI or the consumer expenditure
deflator, and in terms of the headline inflation rate or the core inflation rate is unclear.
Operational Independence
Operational independence is the freedom or ability of a central bank to pursue its objectives
(regardless of who sets them) as it sees fit, without interference or pressure from third parties. It
is not a binary variable but a matter of degree. Operational independence from an elected,
sovereign government is not easily achieved.
It requires political independence: the central bank cannot seek or take instructions from any
government/state body or other institution/body. It requires technical independence: the central
bank must have the tool(s) to do the job. It means that the central bank cannot be coerced or
induced to extend permanent financial assistance to the government or to private agents – it
cannot be raided by government or private actors. It requires financial independence, that is, a
separate budget and a secure capital base. It requires security of tenure and of terms of
employment; this can be achieved through a minimum term of office, removal from office only
for incapacity or serious misconduct (and not for gross incompetence), and pay and other
conditions of employment that cannot be manipulated by outsiders. Finally, it requires that there
be some other independent body, e.g. a court, to settle disputes between the central bank and
the government.
This list suggests that operational independence is not a binary variable but a matter of degree,
that a high degree of operational independence is difficult to achieve and that, if it is achieved,
the central bank is, almost by definition, not substantively accountable to any other agency.
As an illustration of the problems standing in the way of operational independence of the central
bank, consider the issue of its financial independence. The ability of the central bank to pursue
its price stability mandate or, operationally, to achieve its inflation target, is constrained by its

financial resources. Unlike the Treasury, the central bank does not have the power to tax. The
asymmetry is even stronger when hen one realises that among the entities the Treasury can tax
is the central bank. Frequently, the Treasury is also the legal owner of the central bank.
In the UK, for instance, the Treasury owns all the common stock of the Bank of England. This
raises the question: how independent can you be of the party that owns you and is able to tax
you at will? The answer is that this depends on the ability of the Treasury to commit itself not to
deplete the financial resources of the central bank, whether by calling for extraordinary
dividends, through a forced share re-purchase, by taxing the central bank or by raiding its gold
reserves. The credibility of that commitment is determined by the same political factors that
prompted the delegation of monetary policy to an operationally independent central bank in the
first place. It is an open issue.
The financial independence of the ECB is due in no small measure to the fact that the ECB
does not face a single controlling owner, or a single fiscal actor (Treasury or Ministry of Finance)
capable of taxing it. The ECB is owned by the National Central Banks of the European Union.
These in turn are owned (with a number of exceptions) by their national Treasuries/Ministries of
Finance. Raiding the financial resources of the ECB would effectively require the unanimous
agreement of the Finance Ministers of the EU. In addition, the ECB would be able to appeal the
matter to the European Court of Justice. Very few conventional central banks facing a single
national Treasury are in the same comfortable position.
independence of the bank of england
In May 1997 the Government granted the Bank of England operational independence allowing it to
set domestic interest rates. It should be remembered that the government retains control of the final
objective of monetary policy - the Government sets the inflation target within which the Bank must
operate when carrying out monetary policy decisions.
The Bank of England's record since it was made independent in May 1997 has been a strong one.
Underlying inflation has stayed remarkably close to the official target measure of 2.5% (plus or minus
1%). On no occasions has the Governor of the Bank of England been required to write an open letter to
the Chancellor explaining either an inflation over-shoot or an under-shoot.
Gordon
Brown's
Statement
on
Bank
Independence
Now is the time for long-termism. This is the time to set the British economy on a new long-term
course that will deliver high levels of growth and employment through lasting stability.
Price stability is, as I have said, an essential precondition for the Government’s objectives of high and
sustainable levels of growth and employment. The question is how to achieve the long-term stability
that we seek?
Hawks
and
Doves
Attitudes within the Monetary Policy Committee have been characterised as being between the
‘hawks’- members that are consistently more in favour of higher interest rates than others, and the
‘doves’ – those who favour a more relaxed policy. Hawks tend to hold somewhat pessimistic views on
the inflation risks facing the British economy. As a result they tend to favour slightly higher interest
rates in a bid to keep control of domestic demand. Doves, on the other hand, argue that structural
conditions in the economy have changed - and that the economy can continue to grow at a healthy
pace without triggering an acceleration in inflation.
What
is
the
Monetary
Policy
Committee's
The Bank of England Act 1998 formally sets out the role and
In relation to monetary policy, the objectives of the Bank
(a)
to
maintain
price
stability
(ie
continued
(b) subject to that, to support the economic policy of the Government,
growth and employment.

main
responsibility?
constitution of the MPC.
of England shall be –
low
inflation),
and
including its objectives for

The
Inflation
Target
The inflation target the MPC has been given by the Chancellor since 1997 has been a 2.5% increase,
over the previous twelve months, in the retail prices index excluding mortgage interest payments
RPI(X). The MPC has operational freedom how it meets that target. Decisions on what actions need to
be taken to achieve the target are taken by the MPC, on the basis of a majority vote. The MPC's main
role each month is to make decisions on the base rate of interest - the benchmark for the Central
Bank's daily operational of monetary policy in the UK
Monetary
Policy
Activism
Up to August 2001, the MPC has taken fifty-one interest rate decisions and of these twenty changed
the rate. On nine occasions the rate was raised and reduced eleven times. On seventeen occasions the
change was a 0.25% change and three times it has been a 0.5% change. This total suggests that the
Monetary Policy Committee prefers to move in a series of small steps when changing the overall
direction of policy. So, when monetary policy is being tightened, the MPC is likely to increase rates
gradually rather than in larger steps.
Monetary policy in the UK is now much more open and transparent than it was under previous regimes.
Minutes of MPC meetings are published with a two week delay. And the Bank sets out its latest
forecasts for inflation as well as a detailed assessment of macroeconomic conditions in the UK and
overseas through the publication of a Quarterly Inflation Report.
All of Britain's main political parties now accept that the Bank of England should remain independent.
The Conservatives changed their policy stance on this issue well before the 2001 General Election. The
Liberal Democrats have always supported granting the BoE full independence in setting interest rates.
The
Gains
From
Independence
Fall in long term interest rates - long term rates incorporate expectations of future inflation - Investors
require a rate of interest that will take into account the expected rate of inflation. If this falls then the
rate
of
interest
required by investors also falls. A fall in long term interest rates reduces the cost of borrowing for
companies, the government and also mortgage payers. Indeed by August 2001, mortgage rates were
at their lowest levels for forty years.
Inflation has continued to surprise people - the rate of underlying inflation since early 1999 has
persistently under-shot the mid range of the target level. In part this is due to the sustained strength of
the sterling exchange rate, particularly against the Euro since it was launched as a traded currency in
January 1999. The Bank of England has also been helped by a very benign global inflation
environment. Consumer price inflation in the G7 and OECD countries has been falling over the last ten
years.
The general perception is that the Monetary Policy Committee has worked in a harmonious manner
(there have been few if any public disagreements between MPC members) and that their deliberations
have been genuinely free from political influence. Many industrial lobby groups, trade unions and other
organisations seek to influence the MPC in the immediate run up to MPC meetings through the
broadcast and print media. And although the Bank might, on occasions be seen to have acted in part
on the basis of special pleading - there is little substance to this as a criticism.
Inflation expectations have fallen in Britain. The Bank of England can claim some credit for this - if
people believe that price inflation is under control, this is factored into their wage negotiations and
helps to control wage inflation throughout the labour market.

CONCERNS ABOUT AN INDEPENDENT BANK

Monetary "fine-tuning" is an inexact science. Giving the Bank a degree of independence is no
guarantee of macro-economic stability in the long run. A recent study from the National Institute of
Economic and Social Research (NIESR) claimed that had the Bank kept interest rates at 6% during the
first two and a half years of its life as an independent bank, the final outcome in terms of output and
inflation would been broadly similar from the actual out-turn.
MPC may react too easily to short-term economic indicators - it should engage in more research
about long-term economic trends (and structural changes in the economy) to aid its decision-making
If the BOE is too pessimistic about inflation risks in the economy - higher interest rates can
impart a deflationary bias in the economy and risk an economic recession and higher unemployment
Overly aggressive cutting of interest rates might also be de-stabilising for the UK economy in the
medium term
The Bank cannot determine inflation - only influence it in the medium term (the time lags involved
are uncertain)
The Monetary Policy Committee has insufficient expertise in the areas of industry and the labour
market. It is dominated by Bank "insiders" and academics with inadequate real-world experience

Why did the New labour Government Grant Operational Independence to
the Bank of England?
INTRODUCTION
One of the first acts of the New Labour government on coming to power in May
1997 was to grant operational1independence to the Bank of England. An
independent Monetary Policy Committee (MPC) was set up within the Bank with
responsibility for setting interest rates to meet the government’s stated inflation
target. This move arguably constituted one of the most significant institutional
changes in the practice of UK economic policy in the last 60 years. However, given
that interest rates are a powerful economic instrument and policy-lever, why did the
government choose to cede these powers?
Within the central-bank literature, a distinction is made between goal and instrumental (or
operational) independence. If a bank has goal independence then it can set the objectives of
monetary policy, such as price stability or growth. If a central-bank has instrumental
independence then the objectives of monetary policy are set externally but the bank is given
the freedom to control the means by which to achieve its objectives.
1

My objective in this dissertation will be to provide an answer to that question. My
approach will be to use two different strands of ‘new institutional’ theory to provide
two different explanations. The first, based on rational choice institutional theory,
provides what has come to be accepted as the ‘traditional’ theoretical explanation
for central-bank independence. In brief outline, it contends that immediately before
an election, office-seeking politicians motivated by their desire for reelection,
manipulate the economy to create economic conditions favourable with the
electorate but with negative long term consequences for the economy. The result is
a political business cycle; periods of pre-election boom followed by periods of postelection inflation. Central-bank independence therefore, is argued to solve this
economic problem, by insulating monetary policy from political opportunism. In this
dissertation, I challenge this traditional view, arguing that evidence for the
existence of political business cycles based on monetary manipulations, both in the
UK and for other countries is far from conclusive. I also find that the economic
conditions that would have warranted operational independence to the Bank of
England in 1997 were seemingly absent.

Critically examining the theoretical foundations of this argument, I argue that
political business cycle models make a number of assumptions that can be
challenged. Firstly, although advocates of the 2

rational choice explanation argue that governments can and do instigate
inflationary shocks to coincide with the timing of elections, evidence shows that this
is actually very difficult to do, significantly increasing the risks attached to doing so
and so making manipulations unlikely. Secondly, I argue that the ways in which
voters are assumed to form expectations and assessments in political business
cycle models are unrealistic. Thirdly, I argue that the assumption of an exploitable
trade-off between inflation and unemployment, central to political business cycle
models, has been called into serious doubt by the stagflation of the 1970s and the
‘rational expectations’ revolution.
Given that the evidence for the traditional view is shown to be far from conclusive,
why then did New Labour decide to grant operational independence to the bank of
England? My second explanation to the question of this dissertation, based on
normative institutionalism, argues that rather than being a solution to a functional
economic problem, central-bank independence was actually a way of enhancing
public trust and political legitimacy at a time when public opinion was hostile
towards politics and politicians. Responding to the public mood, key figures within
the Labour Party developed certain values for more accountable and decentralised
government which make it possible to explain the decision as the discharge of a
duty to restore public trust. Furthermore, I argue that operational independence was
carried out as a wider exercise in the ‘new public management’ that resulted in
specific form of delegation and that this allowed the government to simultaneously
benefit from the legitimising properties of delegation, whilst retaining strategic
control over monetary policy. From this perspective, although operational
independence was dysfunctional economically, it was a highly functional in terms of
the social, symbolic and political benefits it brought.
The dissertation shall take the following form. Chapter one introduces the ‘new
institutionalism’ and sets it in an historical context. The basic premises and
assumptions that underlie rational choice institutional approaches are then outlined
before describing some of the important applications of the approach. Against this
background, the ‘traditional’ rational choice institutional explanation for centralbank independence is set out. Chapter two formally outlines three theoretical
assumptions of the Nordhaus model of political business cycles. These assumptions
are then critically assessed and the empirical evidence for the existence of political
business cycles reviewed. The final section of this chapter looks at inflation and
inflation expectations in Britain in 1997. I find the theoretical and empirical
evidence for the existence of political business cycles based on monetary
manipulations to be far from conclusive and the economic conditions that would
have recommended operational independence in 1997 Britain to be largely absent.
Chapter three 3
introduces normative institutionalism and sets it in its historical context. The basic
premises of the theory are outlined and against this background the normative
institutional explanation of central-bank independence is presented. Chapter four
presents evidence for public trust and the existence of certain values within the
Labour party in 1997 before operational independence is discussed in and
compared with aspects of ‘new public management’ doctrines. Chapter five
discusses the aspects of operational independence that rational choice institutional
approaches are unable to explain before examining the wider implications of the
normative institutional explanation. The final section concludes.

“Independence signifies ignoring pressures, whatever its source. The independence of central banks
goes, ... beyond independence from political, executive and legislative power. For me it also equates
with independence from private or collective economic interests, autonomy versus the short term,
frequently imposed by capital markets and, finally, freedom of action vis-à-vis the monetary policy of
other central banks.”
Prime Minister Lionel Jospin. Paris, May 2000.
1. Introduction
I am extremely pleased at this invitation to present this inaugural address in the Reuters Forum Lecture
series. This is an important initiative and I wish you well for the sustained success of this lecture
series.
We have chosen to discuss the issue of central bank independence since the topic is both current and
highly significant. Incidentally when the Banque de France organised their bicentennial celebrations in
May this year, they chose the topic of central bank independence as the theme for the colloquium.
At the said Banque de France colloquium, the Prime Minister of the French Republic, Monsieur
Lionel Jospin remarked that: “the increased power and influence of central banks, the greater visibility
of their role and their leaders, have inevitably focused attention on their role, their efficiency, the
principles underlying their actions and, in some cases, their place in the democratic way of life.”
Central banking is of cardinal importance in any country because of the legal right normally granted to
central banks to create money. This money can serve as a means of payment, a unit of account and a
store of value. One of the important issues immediately arising after granting this right to a central
bank, is whether this function should fall under the ultimate control of the executive branch of
government - the cabinet and its administrative departments - or whether parliament should leave this
responsibility to be freely executed by an independent, autonomous powerful institution run by
unelected people.
2. Advantages of an independent central bank
The traditional argument in favour of a strong, independent central bank is that the power to spend
money should in some way be separated from the power to create money. Numerous episodes in the
world’s economic history testify to a government’s potential abuse of its power to create money.
Around the third century AD in the Roman Empire, for instance, the silver coins collected by the tax
authorities were melted and combined with inferior metals, yielding many more coins to spend on the
Caesar’s priorities than the initial tax take. With too much money chasing too few goods, the end
result was high inflation.
Much the same has happened all too frequently with paper money systems. Many governments have
given way to the temptation to reduce interest rates ahead of elections. This may boost spending and
employment in the short term, but ultimately it usually also causes higher inflation over the long term,
unless the capacity of the economy can meet this higher level of demand. This higher inflation,
however, only becomes apparent a couple of years later. An elected government concerned about its
immediate popularity might be tempted to go for the short-term gains from lower interest rates, even at
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the risk of promoting somewhat higher inflation further down the road, because some other political
party may then have to pick up the pieces.
Central bankers normally operate on a longer-term time scale than politicians and therefore do not face
the same temptation to relax policy to achieve short-term objectives. By delegating decisions about
interest rates and other monetary matters to such an independent institution, with a clearly defined
mandate, society can hope to achieve a better inflation outcome over the longer term.
A number of studies have been undertaken to determine whether this argument is valid. These studies
all seem to come to the following three conclusions. Firstly, they provided evidence of a negative
correlation between central bank independence and long-term inflation. A low inflation rate is
therefore more likely to be found in countries with independent central banks than in countries where
the central bank is subject to government control. Secondly, they showed that there is a negative
correlation between central bank independence and the long-term budget deficit expressed as a

percentage of a country’s gross national product. Countries with independent central banks tend to
have smaller budget deficits than those with government-controlled central banks. Thirdly, the studies
in general did not find any evidence of a correlation between the independent status of a central bank
and production growth. It therefore does not follow that production or employment will suffer as a
result of the independent status of the central banks over the medium to long term.
3. Risks of central bank independence
Some critics of an independent central bank argue that although the average inflation rate and the
degree of central bank independence are negatively correlated, this relationship does not reflect any
causal link running from central bank independence to low inflation. They argue that countries where
the electorate is particularly averse to inflation, are more willing to keep inflation down. These
countries are also more likely to have made their monetary authorities functionally independent so as
to help preserve low inflation. Germany, affected severely by the hyperinflation of the Weimar
Republic, is an obvious case in point.
Conversely, countries where the electorate are more tolerant of inflation, are also less inclined to see
monetary policy turned over to an autonomous central bank. These critics claim that average inflation
is determined by history and the preferences of a country’s inhabitants with causality running from
inflation to the institutional structure. According to this view, attempts to impose an independent
central bank and with it a more purposeful anti-inflationary stance in a country tolerant of inflation, are
doomed to failure. The outcry against restrictive policies would simply be too great for the central
bank to withstand.
This argument is not very convincing and does not seem to fit, for instance, the recent experience of
New Zealand. For most of the postwar period the Reserve Bank of New Zealand was one of the least
independent central banks in the OECD. However, in 1988 it was transformed into one of the most
autonomous, with a very clear mandate to fight inflation. This helped the inflation rate to plummet
from double-digit levels to under 2%, which strongly suggests that the structure of monetary
institutions together with the determination to combat inflation, can be highly successful.
Another argument against the autonomy of central banks is that they form part of overall economic
policy and that there can be no meaningful separation between fiscal policy, monetary policy, labour
policy, trade policy or for that matter any other policy measures. If such a separation is attempted and
if policies run at cross-purposes, then conflicting objectives will have to be solved one way or another.
In the process, a conflict between the policies may inflict considerable damage on the economy. There
is clearly substance in the argument that a tightly coordinated package of policies has a better chance
of success than a set of conflicting ones. It can nevertheless be argued that such conflicts may be
inevitable over the short term, as long as central banks have the primary responsibility for controlling
inflation. However, over the long term, stable financial conditions promote sustainably higher
economic growth rates, increased welfare and more employment opportunities.
The main criticism against making central banks autonomous entities is based not so much on
economic as on political arguments. The political argument is that turning over decisions about
3 BIS Review 88/2000

interest rates, exchange rates, the efficiency of the financial system and other monetary matters to a
body of unelected officials, is simply “undemocratic”. In a democratic society, it is argued, all
decisions should be subject to scrutiny by the elected members of the legislature and the concept of an
autonomous central bank is therefore not acceptable. Although there are plenty of other areas of
national life where decision making is delegated to independent unelected officials - the judiciary is a
prime example - there is a fundamental confusion here between being independent and lacking
accountability. No central bank can be totally independent, in the sense that it is not answerable to
anyone. Even the most autonomous central bank has to report in some form or another to the
legislature, which in any case also has the ultimate power to change the laws governing the central
bank. All the same, there is a difference between a situation where policy decisions are under
continuous scrutiny, and an arrangement where the central bank reports to the legislature periodically.
The issue of independence and accountability also turns on the nature of the relationship between the

government and the legislature as the political authorities on the one hand and the central bank on the
other. At the same colloquium mentioned above, Monsieur Jean-Claude Trichet, Governor of the
Banque de France, observed that: “respecting independence does not mean a lack of dialogue, on the
contrary. However, it is true that an independent central bank is neither accountable to the executive
power, nor to parliament, nor any other political institution. In France this was decided by the law
makers, and in Europe by the will of the people and the European Parliaments, which ratified the
Maastricht Treaty.”
In the case of the European Central Bank (ECB), the independence of the Bank is explained under
Article 7 of the Statute which says that: “When exercising the powers and carrying out the tasks and
duties conferred on them by this Treaty and this Statute, neither the ECB, nor a national bank, nor any
member of their decision-making bodies shall seek or take instructions from community institutions or
bodies, from any government of a member state or from any other body.”
The key issues here quite clearly are independence, accountability and dialogue with the political
authorities.
In South Africa the Governor of the Reserve Bank must submit a report annually to the Minister of
Finance relating to the implementation of monetary policy. In terms of Section 32 of the Reserve Bank
Act, the Bank must also on a monthly basis submit a statement of assets and liabilities and annually its
financial statements to the Department of Finance. These reports are then tabled in Parliament by the
Minister of Finance.
Moreover, Section 37 of the Act provides further that if at any time the Minister of Finance is of the
opinion that the Bank has failed to comply with any provision of the act or of a regulation made
thereunder, he may by notice in writing require the Board of the Bank to make good or remedy the
default within a specified time. If the Board fails to comply with such a notice, the Minister may apply
to the Supreme Court for an order compelling the Board to make good or remedy the default, and the
Court may make such order thereon as it deems fit.
4. Conditions for independence
In view of these risks involved in central bank independence, there are usually three preconditions for
central bank autonomy. Firstly, there should be a clearly spelled out legal and operational framework
in which monetary policy is conducted. In the legal framework, the central bank’s independence
should be defined to avoid any misconceptions of what the central bank is supposed to achieve. In the
monetary policy framework, the central bank must indicate what it is attempting to achieve, what
operational variables it will apply and what monetary instruments it will use to achieve its objective.
Because credibility is usually not gained overnight, it is important that a longer-term programme
should be drawn up to show how the central bank will fulfil its mission.
A second condition for greater autonomy is transparency. The government and the public should
continuously be informed of the monetary policy programme followed by the central bank. Regular
discussions between the central bank and the government will be necessary and some form of
accountability to parliament will have to be established. It is also important to explain monetary policy
BIS Review 88/2000 4

decisions regularly to the public, together with an assessment of the progress made in achieving stated
objectives. Priorities in the programme as well as operational instruments should be clearly spelled
out, in order to keep the public well informed about developments and changes in monetary policy.
The third condition for central bank autonomy is the creation of an efficient institutional framework
within which decisions on monetary policy and on its implementation can be made, without undue
interference by political functionaries. This involves decisions regarding:
(i) functional independence, which means the right to decide on all matters regarding monetary
policy and price stability;
(ii) personnel independence, which covers the selection and appointment of Board members
with a high professional competence and without an obligation to yield to political and other
pressures;
(iii) instrumental independence, which means control over the instruments that affect the

inflation process, including in particular the prevention of any direct financing of
government deficits; and
(iv) financial independence, which requires the central bank to have access to adequate financial
resources of its own and full control over its own budget.