BI Institute Publication
Central Bank Policy Mix
By Danny Hermawan
An independent central bank plays a crucial role in achieving price stability as the overarching goal of monetary policy. Research indicates that central banks free from political pressure have higher capacity in terms of implementing sound monetary policy, while central banks encumbered by political influence tend to ignore price stability.
Central banks around the world are faced with several macroeconomic goals, including external balance and output growth, while the literature states that price stability is the single overarching goal of monetary policy by the central bank. In this case, central banks acquiescent to the government may not have credible commitment to price stability, especially when the government has control over monetary instruments and decides to prioritise other policy objectives over price stability. Under such a scenario, politicians merely explore monetary policy for short-term gains in employment and output for electoral purposes, thereby undermining the credibility of central banks in terms of pursuing sound monetary policy objectives.
On the other hand, a fully independent central bank is isolated from political pressure and the commitment to monetary policy is more credible because the central bank can withstand pressures to make short-term policy decisions that contradict long-term policy goals. When a central bank is protected from political pressure, its credibility will increase and the issue of dynamic inconsistency will fade by itself. This is where the literature stresses the importance of mandatory commitment to the rules rather than discretion, emphasising the need to delegate monetary policy to an independent central bank.
Seeking to provide evidence for such theories, researchers collected annual inflation data from the International Financial Statistics (IFS) of the International Monetary Fund (IMF) and Central Bank Independence (CBI) Index, as cipher proxy criteria used to describe bank CEO attributes, including: (i) appointments, dismissals and terms of office, (ii) formulation of bank policies, namely who formulates and has the final decision regarding monetary policy, (iii) the role of the central bank in the budget process, and (iv) the purpose and restrictions on lending to the public sector. The scores were combined into an index from 0 (lowest independence) to 1 (highest independence). The sample countries were classified into four groups: full autocracy, partial autocracy, partial democracy and full democracy, along with two sub-samples, namely advanced economies and developing economies. The scope of data is from 1990 to 2012 for a sample of 176 countries.
The research revealed that central bank independence (CBI) has a negative and statistically significant effect on inflation in countries that pursue full democracy yet an insignificant effect on countries that adopt full autocracy. Even after controlling for the impact of development level and other outliers, the results remain unchanged. In other words, CBI has a negative and statistically significant correlation with inflation in countries that pursue full democracy, irrespective of whether the country is an advanced or developing economy or whether the country records current inflation (outlier) or not. On the other hand, CBI does not have a statistically significant impact on countries that pursue full autocracy, regardless of whether the country is advanced or developing.
The negative effect of CBI on inflation is statistically significant in countries with a partial autocracy system of government yet insignificant in countries with a partial democratic regime. The results imply that a partial autocratic government is more liberal in the management of monetary policy than a partial democratic government. In other words, governments tend to promote real independence of monetary policy management as they move from full to partial autocracy and also return to real independence of monetary policy management as they move from full to partial democracy. It can be concluded, therefore, that CBI has a negative and statistically significant effect on inflation in countries adopting a partial autocratic or full democratic regime yet statistically insignificant in countries that pursue a full autocratic or partial democratic regime.
Salisu, A. A. (n.d.). CENTRAL BANK INDEPENDENCE AND PRICE STABILITY UNDER ALTERNATIVE POLITICAL REGIMES: A GLOBAL EVIDENCE. Bulletin of Monetary Economics and Banking. https://bulletin.bmeb-bi.org/bmeb/vol25/iss2/2/
How do Corporate Sustainability and the Pandemic Affect Cash Holdings in Muslim Countries?
A Relationship Between Digital Services Trade Barriers and Economic Growth
Urgent need to Amend Indonesian Currency Laws to Face the Digital Era
Impact Of Issuing Wholesale Central Bank Digital Currency On Monetary Policy
Circular Economy and Anti-Hedonism Not Just a Dream By Arnita Rishanty
Crypto Investment: Peak, Troughs and Depression By Muhammad Adisurya Pratama