ABSTRACT
Brief review of literature on central bank independence Central bank independence, which is used interchangeably with “policy independence,” can be defined as the flexibility given to the central bank in the formulation and execution of monetary policy and freedom from being dictated by political considerations. However, this definition should not be taken to mean that the government cannot comment on the stance of the monetary policies or the central bank cannot consult with the government on these issues. Broadly speaking, given the definition above, an independent central bank is more likely to implement a restrictive monetary policy and to signal the future course of policy with greater credibility resulting in lower uncertainty. Debelle and Fischer (1994) classify central bank independence into instrument independence and goal independence. Instrument independence refers to the independence of the central bank in using monetary policy tools and is generally viewed as “desirable” in the literature. Goal independence on the other hand, such as aiming price stability and/or output stability, is generally deemed as “undesirable.” Based on accountability grounds, it is argued that since governments are elected from a democratic process, the goals of a central bank should be assigned by the government. The central bank should be free in its choice of means to achieve these goals, whereas the governments are responsible for monitoring the performance of the central bank in fulfilling these goals (successfully). It is also argued that the higher the degree of delegation of decisionmaking in monetary policy, the more explicit monetary devices should be, to provide accountability to the public. A successful implementation of IT requires being able to set a credible target in advance and to do so in successive years without government intervention. Additionally, it also requires the ability to change instruments to achieve the preset target whenever necessary. The first of these requirements calls for goal
independence, and the second, instrument independence. Therefore, one can say that a successful IT requires full independence of the central bank. The public announcement of an inflation target by a central bank necessitates the central bank to act, at least in principle, in conformity to some rules. In an IT regime, for example, these rules are frequent announcements concerning how and why the central bank adjusts its policy rate, or revises inflation targets and inflationary expectations. Such announcements are binding for the central bank and can be made credibly only if the central bank is perceived as independent by the private and public agents. Previous empirical literature reports a negative relation between average inflation and central bank independence.7 One may presume that since there may be a trade-off between output stabilization and inflation stabilization, higher central bank independence may bring about real costs. However, a higher degree of central bank autonomy is found to be unrelated with higher variation in output growth for developed economies by Alesina and Summers (1993), and for OECD economies by Grilli et al. (1991). The issue of central bank independence has been approached from other directions as well. Some studies have focused on the proper measurement of central bank independence. Posen (1995), for instance, suggests that the measurement of central bank independence in such studies based on legal codings may not be capturing central bank independence accurately and/or the assumptions on central bank independence are in fact inappropriate. Measuring central bank independence is difficult when different countries with heterogeneous market structures are subject to the analysis. In order to measure central bank independence, several indexes have been employed in the literature. The most common and comprehensive belongs to Cukierman et al. (1992). Bade and Parkin (1984), Alesina (1988) and Grilli et al. (1991) provide alternative measures. Cukierman et al. (2002) updated the central bank independence index of 1992 for the 26 former socialist economies in order to study these economies during the period of transition to liberalization in the 1990s. Similar studies for Latin American and Caribbean countries during the 1990s were conducted by Gutierrez (2003) and Jacome and Vazquez (2005). Finally, among the most recent studies, Arnone et al. (2005) employ the current versions of the OECD data that were previously studied by Grilli et al. (1991). Hayo and Hefeker (2001) stress the endogeneity issue for studies focusing on the degree of central bank independence and disinflation. Although a strong correlation between independence and low inflation exists in most cases, they argue that this finding does not imply causality since societies with “inflation culture” are more inflation averse and give priority to price stability as a policy objective and then central bank independence takes place as a result. They also propose other solutions to the time-inconsistency problem, such as inflation targeting or exchange rate based monetary policies. Another direction in the central bank independence literature is the issue of legal (de jure) and actual (de facto) independence of central banks. Cukierman (1993) shows that inflation and legal independence are in fact negatively related in developed countries and there
exists no such relation in developing countries due to this dual aspect of central bank independence.
