Front Matter Page

Central Banking Department

Table of Contents

• • Summary

• I. Introduction

• II. Central Banking and Monetary Policy--A Brief Review

• III. The Case for Monetary Policy Independence

  • 1. Policy credibility

  • 2. Empirical evidence

  • 3. Complications and counterarguments

• IV. Dimensions of Monetary Policy Independence

  • 1. Formal monetary policy responsibility and conflict resolution

  • 2. Statutory objectives

  • 3. Monetary policy accountability and monitoring

  • 4. Role and composition of central bank boards

  • 5. Appointment and dismissal of management and directors

  • 6. Limits on financing of government

  • 7. Central bank budgetary independence

  • 8. Constraints on the use of monetary policy instruments

• V. Associated Functions of Central Banks

  • 1. Exchange rate policy

  • 2. Lender of last resort

  • 3. Prudential supervision

  • 4. Deposit insurance

  • 5. Other financial sector regulation

  • 6. Fiscal agent

• VI. Conclusion

  • References

Summary

The theoretical rationale for central bank independence derives from the conviction that effective and efficient monetary policy depends on public trust in how monetary policy operates and in what it seeks to achieve, and that central bank independence can contribute importantly to establishing and maintaining such “credibility.” However, empirical evidence to date, though suggestive, is less than conclusive in linking the degree of central bank independence with macroeconomic performance. The implication is that the exact nature of institutional arrangements to establish such independence has to be studied, taking into account the possible objectives and motivations of central banks themselves and the interaction with those of political leaders.

This paper discusses the concept of independence and the institutional arrangements needed in practice to bring about a desired degree of independence. Among these factors are the institutional process for determining monetary policy, including legal arrangements for the resolution of conflicts; the nature of objectives specified for the central bank, particularly those articulated in its statutes; accountability and public monitoring of monetary policy performance; the role of central bank boards; procedures for appointment and dismissal of central bank management and directors; rules governing the central bank budget; legal constraints on central bank funding of the government; and legal and institutional constraints affecting the use of monetary policy instruments.

The degree of independence may also be affected by other nonmonetary policy functions assumed by the central bank. These include management of exchange rates, international reserves, and public debt; lender-of-last-resort functions; prudential supervision; deposit insurance; and general financial regulation (for example, licensing). If there are conflicts between such functions and monetary policy, the independence of the central bank may require a reconsideration of the allocation.

The paper also notes that central bank independence by itself cannot guarantee monetary policy credibility, which depends ultimately on the credibility of economic policy as a whole. However, central bank Independence may indirectly contribute to restraint in other policies.