Independence of the Central Bank results in low average inflation rates with minimal variance, which provides a conducive environment for high and sustainable growth.
Part I explored the inherent growth bias in an elected government and the reason why the government would be willing to tradeoff higher growth rates for a slightly increased inflation rate. The short run Phillips curve explains this phenomenon, while the Long Run Phillips Curve or the Expectations Augmented Phillips Curve shows that there is no long run tradeoff between the two variables in the long run and further, that any policy that tries to take advantage of the short run Phillips curve will end up with lower growth rate and a higher inflation rate. While fiscal policy still falls trap to the short run Phillips curve in many countries today, subjecting monetary policy to this line of thought will result in a stagnated economy with high inflation, which has very real economic costs to the population.
Milton Friedman, in all his wisdom, demonstrates the effects of monetary policy conducted with short term visions:
When the alcoholic starts drinking, the good effects come first; the bad effects come only the next morning, when he wakes up with a bad hangover – and often cannot resist easing the hangover by taking the ‘hair of the dog that bit him’.
The parallel with inflation is exact. When a country starts on an inflationary episode, the initial effects seem good. The increased quantity of money enables whoever has access to it – nowadays, primarily government – to spend more without anybody having to spend less. Jobs become more plentiful; business is brisk, almost everybody is happy at first. Those are the good effects.
But then the increased spending starts to raise prices. Workers find that their wages, even if higher in dollars, will buy less; businessmen find that their costs have risen, so that the higher sales are not as profitable as had been anticipated unless prices can be raised even faster. The bad effects are emerging: higher prices, less buoyant demand, inflation combined with stagnation.
As with the alcoholic, the temptation is to increase quantity of money still faster.. In both cases, it takes a larger and larger amount of alcohol or money, to give the alcoholic or the economy, the same ‘kick’.
— Milton Friedman in Money and Mischief: The Cause and Cure of Inflation.
This is the theoretical case for Central Bank independence which has a long term vision.
Empirically, economic literature on this subject is not definitely in favour of central bank independence, though the dominant thinking is for independence. Grilli, Masciandaro, and Tabellini in 1991 developed an index for measuring central bank independence. The index mainly tried to measure two factors: political independence and economic independence. These factors comprise the following sub-factors:
Mainly, central bank independence has to be thought of in two main areas. Firstly, does the central bank have goal independence? Many central banks are given the mandate of price stability or the dual mandate of growth and price stability by the government. Secondly, does the central bank have operational/instrumental independence? In this kind of independence, the central bank can choose its instruments for achieving its policy goals and the timing of its use.
The strongest evidence for central bank independence is given by a simple regression plotting level of inflation and measures of central bank independence. The figure below shows inflation and central bank independence for industrialized economies using data from 1955 to 1988.
More modern studies have also been able to replicate this particular relationship.
Finally, studies have also shown that central bank independence is strongly correlated with lower variance in inflation. The Alesina and Summers paper show this graphically for the same period.
Thus, central bank independence results, more often than not, in low and stable inflation rates. Low and stable inflation rates, as economic theory has repeatedly proved, provides a conducive environment for GDP growth.
Thus, to achieve high growth rates, the central bank must be independent and must strive to achieve low and stable inflation.
Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur