Central Bank Independence and Economic Performance

Article excerpt

IN RECENT YEARS MANY countries have adopted or made progress toward adopting legislative proposals removing their central banks from government control, that is, making them independent. Between 1989 and 1991, New Zealand, Chile and Canada enacted legislation that increased the independence of their central banks. The 1992 Treaty on European Union (Maastricht Treaty) requires European Community (EC) members to give their central banks independence as part of establishing the European Monetary Union. As a result, EC countries that do not yet have strongly independent central banks have introduced legislation or announced their commitment to make their central banks more independent.(1) Furthermore, in recent months the governments of Brazil and Mexico have announced their intentions to introduce legislation to create more independent central banks.

In view of these developments, it might seem reasonable to conclude that unambiguous links had been established between economic performance and the degree of central bank independence. Interestingly, however, the two post-World War II star performers among the industrialized economies--Germany and Japan--have different levels of central bank independence. The German Bundesbank is viewed as one of the most independent central banks in the world, whereas the Bank of Japan is seen as more subject to government control. Thus the contrast between the movement to grant central banks more independence and widely different degrees of independence across the major economies raises several questions. Among these are: Why is the idea of an independent central bank popular? Are there economic benefits of having an independent central bank? This paper examines empirical and theoretical studies of central bank independence to address these questions. Empirical researchers have devised measures of independence to focus on the relationship between central bank independence and a country's economic performance. Theoretical studies have modeled the strategic behavior of monetary and fiscal policymakers to be able to compare an economy's performance when policymakers cooperate in setting policies with its performance when they do not cooperate.

The next section of this paper presents a survey and evaluation of empirical studies.-Next, theoretical studies are presented and evaluated. The final section examines the extent to which these studies either explain the current movement toward greater central bank independence or highlight unresolved questions in this debate.


Inflation and Central Bank Independence

As a broad generalization, interest in central bank independence was motivated by the belief that, if a central bank was free of direct political pressure, it would achieve lower and more stable inflation.(2) Bade and Parkin (1985) conducted one of the first empirical studies of this link. The authors used data for 12 Organization for Economic Cooperation and Development (OECD) countries in the post-Bretton Woods era and measured the degree of central bank independence according to the extent of government influence over the finances and policies of the central bank.(3) The degree of financial influence on the central bank was determined by the government's ability to set salary levels for members of the governing board of the central bank, to control the central bank's budget and to allocate its profits. The degree of policy influence was determined by the government's ability to appoint the members of the central bank governing board, government representation on this board, and whether the government or the central bank was the final policy authority. Countries were given a rank of one through four in each category, with four being the highest level of central bank independence.

Bade and Parkin concluded that the degree of financial independence of the central bank was not a significant determinant of inflation in the post-Bretton Woods period. …