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
1979
1980
1983
1984
1985
Germany
4.0
5.4
3.3
2.4
2.1
United States
11.3
13.5
3.2
4.3
3.5
United Kingdom
13.4
18.0
4.6
5.0
6.1
Country