Magazine article Economic Trends

Central Bank Independence

Magazine article Economic Trends

Central Bank Independence

Article excerpt

New Zealand has succeeded dramatically in lowering inflation. Its annual average inflation rate over the 1955-88 period was 7.6%, but from 1989 to 2000, it averaged 2.7%. Once higher than other industrialized nations, it is now among the lowest. The critical development that made this change possible was the passage of the 1989 Reserve Bank of New Zealand Act, which instituted inflation targeting; perhaps more importantly, it granted the central bank more independence. Formerly considered the least independent, New Zealand's central bank now ranks among the more independent ones. Other nations have also made their central banks more independent.

Central bank independence is very important in keeping inflation low over long periods. The idea is to limit the fiscal authority's ability to influence monetary policy because it may have more incentive than an independent central bank to) inflate in order to achieve, say, a lower exchange rate, a higher output level, or a lower level of inflation-adjusted debt.

The data suggest that countries with more independent central banks do have lower inflation rates. From 1955 to 1988, when New Zealand had one of the least independent central banks, it had one of the highest inflation rates. At the other extreme, Switzerland, with one of the most independent central banks, enjoyed a 3.2% inflation rate, one of the lowest.

The same relationship is apparent from 1988 to 2000. Iceland, one of the least independent central banks, has had the highest inflation rate (6.2%). Japan's central bank is considered among the most independent, and its inflation rate has been the lowest. Clearly, other factors contribute to Japan's low (some would say too low) inflation rate.

The impact of independence on inflation seems pretty stable across time. We can use linear relationships to deduce how much New Zealand's dramatic improvement in independence would be expected to have lowered its inflation. …

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