The negative relationship between CBI and the inflation rate

Central Bank Independence and Its Importance

Central banks have undergone numerous modifications around the world over the years. The Federal Reserve Bank, the Swiss National Bank, and the German Bundesbank were the first banks granted legal independence. The incorporation of the CBI into law led to the adoption of autonomy in the functioning of central banks in numerous countries. Although most central and reserve banks are independent of the government and political institutions, the various cases of economic depression in various countries have prompted policymakers to reconsider central banks’ independence and their effectiveness in achieving macroeconomic policy objectives in an economy. In South Africa, for instance, there have been a disagreement over the independence of South African Reserve Bank (SARB). There are suggestions for SARB to shift its core mandate from inflation and currency stability control to realization of economic growth in the country. However, such suggestions have met criticism from policymakers who claim that SARB must implement its core mandate of maintaining a sustained levels of inflation and controlling prices in the economy. Although, there are mixed reaction to this issue, there is need to ask the question, ‘should SARB be independent?’ Is there need for government to intervene on the actions of the central bank?

Introduction

Central bank independence can be defined as the freedom of monetary and fiscal policymakers from the influence or interference by the government or politicians. Over the years, the interaction between the central bank and the government have been given much focus. Several economies experienced sustained levels of inflation due absence of governmental or political interference to the actions of financial institutions like central bank (Acemoglu and Robinson 2013, p.180). In fact, the intervening factors between the actions of the central bank and the overall impact on the economic performance of a country have been assumed to be insignificant. However, the central bank’s unlimited inability to create money in the economy have been treated as the major factor affecting their effectiveness of various monetary policies (Palley 2015, p.18). Due to the current actions taken by the central banks and how such actions affect the economic actors, there are need to question the independence of a central bank as an institution that not only dictates money supply in the economy but also has the power to alter the prevailing interest rates in an economy. The paper seeks to provide arguments supporting the need for a central bank to be an independent institution. Moreover, it utilizes the available evidence showing that central bank independence is beneficial for an economy. Thus, this paper supports the view that central banks should be taken as a stand-alone entity within an economy.

Arguments for Central Bank Independence

The negative relationship between CBI and the inflation rate

One of the key role of the central is to control the rate of inflation in an economy through regulation of money supply, interest rates, and bank rates. When central bank is not independent (or having low levels of independence), then it becomes problematic to maintain a sustained levels of inflation in an economy. According to Acemoglu and Robinson (2013, p.180), the independence of the central bank can be used as the key tool used to deal with unsustained levels of inflation in an economy. There is a negative relationship between central bank interest rates and the rate of inflation in an economy.

The amount of interest rates set by the central bank determines the ability of members of the public and financial institutions to borrow money at the prevailing rates (James 2014). Thus, it determines amount of money circulating in the economy. Thus, the central bank must be able to implement policies that seek to control the levels of interest and bank rates without interference from the government or other agencies. However, Palley (2015, p.18) argues that the inflation controlling culture requires the involvement of the government and other financial institutions. Thus, the central bank must assure people that it’s serious with controlling inflation by adopting financial policies that concur with the inflation control goal. Moreover, the government must maintain low budget deficits to ensure that government income structure is highly dependent on revenue and not borrowing (Baker, Newell and Phillips 2014, p. 802). Government interference on will affect the independence of the institution thereby exerting unnecessary pressure on monetary policies. This causes temporary price instabilities thus affecting central bank credit and implementation of the stability programs.

Based on empirical evidence, central banks have the ability to promote high rates of employment financial stability, and economic growth through maintaining price stability and sustained levels of inflation. However, monetary policies alone cannot achieve these goals without the involvement of the government through fiscal policies (Palley 2015, p.18).

Government Manipulation of the Monetary Policies for their own Benefits

It is agreed that political authorities and policymakers are responsible for formulation of monetary policies. However, the implementation of such policies should be free from political influence in order to achieve the desired policy objectives. According to Bodea and Hicks (2015, p.50), central banks can easily achieve the desired monetary policy objectives without compromising the economic growth if they act free from political pressure. In most situations, governments tend interfere with the independence of the central bank so that they can find avenues to abuse the bank’s money creation powers. This is because the government are tempted to finance their budget deficits through money creation. Moreover, increased money supply in the economy have a negative effect on the inflation rates and price levels in an economy. Taylor (2013, p.158) adds that governments may want to report low cost of leaving and inflation levels so that they can increase income tax or reduce wages.

The lack of independence of the central bank can make other financial institutions and members if the public deem their actions incredible. Workers may end up demanding higher wages while businesses respond by increasing the prices of goods and services. While higher wages and revenues may be realized in the short run, such actions may lead to high levels of inflation in the long run, thus failing to realize higher output or employment levels (Bodea and Hicks 2015, p.50).

Politicians Change Monetary and Fiscal Policies to Win Elections

Politicians have a tendency of manipulating the monetary and fiscal policies around the election periods to win elections. For instance, the need to finance political campaigns make politicians attempt to adopt expansionary monetary and fiscal policies to lure the public. Policies lack increased money supply and reduced taxes or increased salaries may be beneficial in the long run but the long term effects may be unbearable. In most cases, there are budget deficits before election periods makes politicians find for ways to raise funds for increasing public expenditure to lure the voters. According to James (2014), absence of central bank independence can always a country into a crisis during election periods. Politicians can try to influence central banks to rush into implementing expansionary policies so that short run effects can be felt before an election thereby making them to gain electoral support.

Arguments against Central Bank Independence

Non democratic Legitimacy

Central banks tend to be very conservative especially in making policies decisions and implementation of such policies. The independence of the central bank guarantees absence of interference from external forces like the government or politicians. However, due to economic dynamics and fluctuations in the macroeconomic indicators, the ruling government may have a different policy intervention compared to the central bank and the opposition. In such situations, the central bank may insist on maintaining the previous policies until the suggested policies are proven real in solving the problem (Bodea and Hicks 2015, p.50). Due to political pressure, disagreement between the ruling government and the opposition may result into more controversies. For example, the ruling government may suggest new policy intervention to solve the natural unemployment in an economy. Due political differences, the opposition may oppose the policy rendering it useless. Since the central bank is independent, they may continue implementing the previous policies hence failing to address the unemployment problem.

No accountability

The main role of the central bank is to control prices and inflation levels in an economy. Such independence can make the government think that control prices and inflation is the role of the central bank alone. According to Bodea and Hicks (2015, p.50), politicians and government may implement expansionary fiscal policies that destabilizes the level of prices and inflation in a country. Since they are not directly responsible for the controlling inflation, their decisions may affect the economic stability in a country. Taylor (2013, p.158) argues that although a higher degree of independence is needed for smooth operations of the central bank, government intervention is needed so that they can have some degree of responsibility in achieving the desired macroeconomic objectives.

Inconsistent economic policy

Monetary policies implemented by the central banks are always short term in nature hence failing to achieve the long term goals. Faster growth rate and unemployment reduction can be achieved in the short run using expansionary monetary policy. However, the policies tend to increase inflation rates and prices levels in an economy thereby altering economic growth rate. Due to pressure from the government or politicians, central bank may implement a policy that is short-run focused (Bodea and Hicks 2015, p.50). To help solve these inconsistencies, the government should closely work with central bank to formulate consistent policies that can help achieve the desired macroeconomic goals.

Bureaucratic Behavior

The central bank tend to maintain autonomy and avoid conflict from the government and politicians. This makes it difficult to implement various policies needed to achieve economic growth. Moreover, the government is responsible for ensuring growth while they find it difficult to implement the policies given the bureaucratic nature of the central bank.

My Stand

Although there is need for the central bank to be autonomous from political control, there is need for governments to closely work with central banks to ensure monetary and fiscal policy mix are adopted in achieving both short term and long term policy objectives. The government and policymakers must closely work with the central bank to ensure that concerned parties are directly involvement in the formulation and implementation of monetary and fiscal policies. However, the central bank must be in full control over money supply in the economy. The Reserve Bank should focus on inflation, currency stability, and economic growth. Besides, the independent institutions should closely work with the government to bring the desired change.

South African Reserve Bank should therefore work closely with the government and policymakers in implementing the expansionary monetary and fiscal policies while still maintain a level of control on their policy decisions.

Conclusion

Central Bank Independence is a necessary tool needed to avoid cases of government and political influences. However, the emerging cases of economic depression and higher rates of inflation needs a combined effort in policy formulation and implementation. The South African Reserve Bank (SARB) should ensure that they perform their roles as stipulated in the constitution. Moreover, SARB should make their financial decisions without influence from politicians who may want to achieve short term goals to lure the electorates. In order to solve achieve the long term policy goals, SARB must work together with the government in implementing expansionary monetary and fiscal policies needed for the country to realize employment creation, controlled inflation, and economic growth in the economy. Besides, the government must also be responsible for ensuring that strict laws are formulated to protect the independence of the central banks from the actions of politicians.

References

Acemoglu, D. and Robinson, J.A., 2013. Economics versus politics: Pitfalls of policy advice. The Journal of Economic Perspectives, 27(2), pp.173-192.

Baker, L., Newell, P. and Phillips, J., 2014. The political economy of energy transitions: The case of South Africa. New Political Economy, 19(6), pp.791-818.

Bodea, C. and Hicks, R., 2015. Price stability and central bank independence: Discipline, credibility, and democratic institutions. International Organization, 69(1), pp.35-61.

James, D., 2014. Money from nothing: indebtedness and aspiration in South Africa. Stanford University Press.

Palley, T.I., 2015. Money, fiscal policy, and interest rates: A critique of Modern Monetary Theory. Review of Political Economy, 27(1), pp.1-23.

Taylor, J.B., 2013. The effectiveness of central bank independence vs. policy rules. Business Economics, 48(3), pp.155-162.