Central bank independence and the conduct of monetary policy - Essay Example

Central Bank Independence and the Conduct of Monetary Policy Table of Contents Table of Contents 2 Introduction 3 2. The Central Bank Independence & Framework of Monetary Policy 4 2.1. Basic Concepts in Monetary Policy 4 2.2. Essential Macroeconomics Concepts 6 2.3. Theoretical Underpinnings for Central Bank Independence 7 2.4. Empirical Support for Central Bank Independence 7 2.5. Inflation & Central Bank Independence 8 3. Conclusion 9 4. References 10 5. Bibliography 12 1. Introduction Independence of the Central bank implies that the monetary policymakers are free from direct influence from the government or from the political front while conducting the policies.

During the period of 1970s and in the beginning of 1980s, main industrialised economies witnessed constant stage of increased inflation (Walsh, 2005). A central bank that is independent enjoys freedom while planning its instrument of policy in order to attain its purpose. In order to have functional independence, it is necessary for the main purpose of the nationwide central bank with regard to a state which is a member of the EU, to be planned in a transparent and lawfully certain way. It is also required to be completely aligned along with the main purpose of price steadiness (Smaghi, 2007).

To be more precise, the concept of central bank independence means that the bank enjoys complete independent authority in planning the degree of short-term rate of interest with regard to the ‘money market’ (Smaghi, 2007). 2. The Central Bank Independence & Framework of Monetary Policy In the earlier years, there have been certain absolute alterations made in the legislation of the central bank in order to boost the legal independence for the bank. The alterations made in the legislation provide more power to the central bank and facilitates it to emphasise chiefly on the purpose of price stability.

The issue of price stability is given priority from the other issues such as high employment, low interest charges, growth or funding the deficits in budget. Independence provided to the Central Bank with the intention to keep up price stability has proved to be successful in keeping down the inflation rates relatively low for quite an extended time period. For instance, the Swiss National Banks and the Bundesbank have been effectively successful in maintaining stability in prices. Therefore, it can be stated that the vital purpose of the monetary policy designed by the independent central banks is to uphold stability in prices by effectively managing the inflation (Cukierman, 1994). 2.1.

Basic Concepts in Monetary Policy The mechanism of the monetary policy is a process with the help of which alterations in the supply of money have an effect on employment, equilibrium of payments, output and inflation as well. For instance, any increase in the supply of money would imply that there would be more availability of money for the people to expend on assets that are financial in nature. As a result, the cost of the financial assets would increase. It is a known fact that there exists an inverse relationship among the rate of interest and the cost of the financial assets.

To further understand this concept, it is assumed that there has been an issue of a certain government bond for £1000 and which is expected to pay an interest of 10 per cent which makes it £100. Now, if assumed that the price for that particular bond went up to £2000 then the interest of £100 would be now 5 per cent. Therefore, it indicates that an increase in the costs of the financial assets would result in decreasing the interest rates. Decrease in the rate of interest encourages investment along with consumption.

They even tend to lessen the requirement for currency by way of lowering the value as well as increasing the export demand and lessening the import demand concurrently (Grant & Vidler, 2000). The main purpose of a central bank is that of defending the worth for the currency with regard to what it would buy. Inflation or rising price decreases the value for money. Monetary policy is being aimed at for attaining this purpose and providing a structure for economic growth that is non-inflationary.

For instance, like the other different developed economies, the monetary policy of the UK, functions by controlling the rate of interest at which the money is being lent out. However, the Monetary Policy Committee of the bank declared in 2009 March that apart from setting the rate for the bank, it would also begin to insert money in the economy directly by the way of buying assets which is also known as ‘quantitative easing’. This implies that the implementation of the monetary policy would move in the direction of the amount of money given compared to the price or the charge of interest at which the lending as well as borrowing is done by the Bank.

Decrease in inflation is quite an important factor as it assists in promoting long-term steadiness with regard to the economy. Stability in price is considered as a prerequisite for attaining a broader economic purpose pertaining to employment as well as sustainable growth (Bank of England, n.d.). 2.2. Essential Macroeconomics Concepts Macroeconomics is a study related to the complete exploitation of the natural resources. These resources are known to have significant impact on the national income, effective demand, employment, cumulative demand as well as supply, total saving, level of price, total investment and thus affect the overall economic development.

The essential concepts of macroeconomic includes the idea of national income, the various elements present in it, methods of measuring those elements and social accounting (Jain & Khanna, n.d.). Secondly, macro economics deals with the concept of employment. It studies and investigates the different problems of unemployment as well as employment. The various factors ascertaining employment such as effective demand, total saving, aggregate supply, total investment, aggregate demand, multiplier and total consumption among others form a part of this concept.

Macroeconomics deals with the concept of money that is the alterations in the supply as well as demand of money and their implications, concept of general price level that is the problems relating to inflation as well as deflation, economic growth, international trade, wealth distribution and also the aspect of business fluctuations (Jain & Khanna, n.d.). 2.3. Theoretical Underpinnings for Central Bank Independence The thought of permitting formal “independence” to any Central Bank is an approach to enhance the particular country’s inflationary performance.

The related theoretical underpinnings for those declarations are that the reliability of the monetary policy is considered to be improved at the time of putting it to practice by the particular independent Central Bank, because the pressures by the government with regard to an additional expansionary stance could be opposed (Mangano, n.d.). 2.4. Empirical Support for Central Bank Independence The legal independence of Central Bank in the industrial countries was examined and an opposite correlation existing among the standard inflation and independence measures (Maliszewski, 2000).

According to the empirical evidences there has been found few noteworthy weaknesses which deals quite a serious blow with regard to the justification provided theoretically for the Central Bank Independence (Mangano, n.d.). 2.5. Inflation & Central Bank Independence Numerous observers identified the fact that the degree of inflation was significantly less in those countries where the Central Banks functioned independently in comparison to those countries where the banks were under direct control of the government.

This is because on the fact that there is a lot of political pressure faced by the monetary authorities to act in harmony with the preferences of the government. Tightening of monetary intensifies the government’s budgetary position. Another reason is said to be the difference between the fiscal and the monetary authorities. The other reason observed behind this relationship is reliant on the problem of ‘time-inconsistence’. Dynamic inconsistency occurs when a plan which is considered to be the best in agreement with the current scenario for a future period remains no more the best at the actual start of the period (Eijffinger & Haan, 1996). 3. Conclusion It was observed that numerous countries have approved increased independence to their central banks but the thought of the banks being entirely independent has been under criticism.

The criticism emphasises on the hazard of the lack of accountability for an independent central bank. However, maintaining higher degree of stability and lower degree of inflation is viewed to be an immensely significant societal aim but yet it does not emerge to be the sole macroeconomic aim. Monetary policy might not have an impact in the long run on the actual economic variables; however it is capable of affecting the economy for a short-term period. Therefore, it has been recommended to ensure certain amount of accountability for the independent central banks (Walsh, 2005). 4. References Bank of England, No Date.

Monetary Policy. Home. [Online] Available at: http://www.bankofengland.co.uk/monetarypolicy/index.htm# [Accessed August 29, 2011]. Cukierman, A., 1994. Central Bank Independence And Monetary Control. The Economic Journal [Online] Available at: http://www.jstor.org/pss/2235462 [Accessed September 5, 2011]. Eijffinger, S.C.W. & Haan, J.D., 1996. The Political Economy of Central-Bank Independence. Special Papers In International Economics, pp. 1-70. Grant, S. & Vidler, C., 2000. Economics in Context.

Heinemann. Jain, T. R. & Khannam, O. P., No Date. Economic Concepts and Methods. FK Publications. Maliszewski, W. S., 2000. Central Bank Independence in Transition Economies. Centre for Social and Economic Research & London School of Economics and Political Science. Mangano, G., No Date. Measuring Central Bank Independence: A Tale of Subjectivity and of its Consequences. Lausanne University and London School of Economics, pp. 1-32. Smaghi, L. B., 2007. Central bank independence: from theory to practice.

Functional Independence [Online] Available at: http://www.ecb.int/press/key/date/2007/html/sp070419.en.html [Accessed September 5, 2011]. Walsh, C.E., 2005. Central Bank Independence. University of California p.p. 1-10. 5. Bibliography Buckle, M. J. & Et. Al., 2004. The UK Financial System: Theory and Practice. Manchester University Press. Gali, J., 2008. Monetary Policy, Inflation And The Business Cycle: An Introduction To The New Kaeynesian Framework. Princeton University Press. Shinnick, E., 2008. Public Finance, Monetary Policy and Market Issues.

LIT Verlag Munster. Smits, R., 1997. The European Central Bank: Institutional Aspects. Kluwer Law International. Quaglia, L., 2008. Central Banking Governance In The European Union: A Comparative Analysis. Routledge.