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This article aims at discussing Central bank independence (CBI) contributions towards attaining long-term price stability, reviewing alternative monetary policy instruments that can achieve low inflation rates, focusing on fixed exchange rate currency board arrangement, inflation targets as well as central bank contracts.
Effects of CBI to inflation on a monetary policy regime
Barro and Gorden (1983) start with the idea that the monetary authority is a social welfare maximizer with control over the rate of inflation; objectives are defined over employment (or output) and inflation. Based upon rational expectations wage setters foresee these incentives and incorporate the expected rate of inflation into their nominal wage. Assuming objective function of monetary authority is publicly known, the expected inflation will reflect the equality between marginal gain and cost of inflation.
The actual rate of inflation will be equal to the expected rate of inflation. No monetary surprise no employment gains, but a positive rate of inflation. To avoid positive rates of inflation that have no benefits a mechanism by Rigoff (1985) proposes appointing someone whose preference is known to diverge from relative weight on avoiding inflation than unemployment.
Independence, conservation and political influence
Input in this argument is the equivalence of independence and conservation. Several problems are making the two concepts equivalent the negative empirical relationship between CBI and inflation typically breaks down in a sample of third world countries. Longami and sheets (1997) conclude that CBI has a beneficial effect on inflation in Eastern Europe. They find for a single point in time that CBI is negatively correlated with inflation, the major setback being that it does not take into account the average of inflation rates over time. CBI is not related to price stability however after countries achieve economic liberalization and condition in price control and wars CBI appears to be negatively correlated with inflation. (Cukierman, 2000)
On the relation between CBI and low rate of inflation Maxfield (1997) indicates that there is a great difference in independence according to some indexes. One further standard argument for creating legally independent central bank to avoid political business cycle by government trying to improve their re-election chances solution to this is by delegating monetary policy away from the government. In cases where governments are unable to set monetary policy, neither are they able to use this tool to pursue political business cycle. CB that is formally independent can be influenced politically via appointment procedure.
Shocks on CBI to the economy
Government may want to override independent CB’s in case of particularly large negative shocks to the economy this restricts the independent CBS in case of particularly large positive shocks to the economy. However, in the equilibrium the government will therefore cure large output shocks. Cukierman (1994) puts forward a related argument, he points out that economic and political variables influence the degree of legal independence granted to central banks. Therefore the CBI should be higher when there is greater political uncertainty, large government department and stronger preferences for low unemployment.
Price stability and CBI
This involves means of bringing about low and stable rates of inflation. One of the means, which has received much attention to transition in the emerging and developing countries, is the choice of a fixed exchange rate as a monetary policy regime.
Credible exchange-based monetary policy must take the form of a full monetary union as a currency board. The monetarist take care of constraining CBS by a constitutional monetary policy once here CB discretion is reduced to the choice of instruments to achieve the goals formulated precisely in the monetary policy rule.
Politically interested groups
Commercial bank fears inflation thus prefers conservative monetary policy. As banks usually borrow short and lend long they are vulnerable to the spread of interest rates. For banks higher interest rates can lead to problems recovering loans. The financial sector that determines CBI runs fluctuations of inflation rates should over time correspond to financial sector lobbying casual evidence does not suggest a close correspondence but this is an issue deserving more attention.
Bagheri and Habibi (1998) looks at the relationship between CBI, political liberty and instability. They find both political liberty and stabilization linked to CBI, countries that move political freedom and are characterized by less regime and political party instability show high degree of CBI, the conjunctive that CBI changes when countries move from nondemocratic to the democratic political system. This CBI is directly related to the nature of countries’ political systems.
Labor Market Institutions
Where there are weak labor unions, labor is considered as being a domestic and no account is taken of strategic interaction between labor and central banks. If labor unions are not atomistic but organized, one should expect labor units to internalize to a certain degree the negative effect of high wages on employment and inflation. Labor unions will discipline their wage demand if they too have an interest in low rate inflation. A government and stable prices are, therefore, better of fixing the level of unemployment benefits and social transfers in real terms and appointing a conservative central banker.
European Journal of Political Economy, Vol. 18 (2002) 653-674.