Central bank independence (CBI) is usually understood as the central bank’s ability to control monetary instruments. On the other hand, CBI can also be seen as a set of restrictions on the government’s influence on the management of monetary policy by the central bank.
CBI has tended to occur in countries with history of high levels of inflation and in more democratic countries. More independent central banks are usually more transparent, which correlates in turn with institutional quality. And greater independence of central banks is associated with lower levels of inflation.
But the degree of CBI varies considerably across countries regardless of the regulatory set up or the health of the country’s democracy. Insulating monetary policy from the political processes (by having an independent central bank) enforces low inflation. Maintaining the assumption that monetary policy has real impacts provides some insights; an independent central bank that is free from political pressure behaves more predictably and promotes price stability, which eventually leads to economic growth.
In order to have a fresh insight based on the latest data available, a set of 31 developed and developing countries have been examined over the period of 1970-2015 using fixed effect regression to provide new evidence on the impact of CBI on economic growth.
The figure below depicts the interaction between CBI and growth once data is pooled. It shows a negative relationship between the two variables.
In order to see whether the CBI and growth interaction would differ across developing and developed countries, some control variables are introduced which might mediate this impact.
After running the regression for the full sample, the panel threshold regression enables us to determine a threshold level of PPP GDP per capita to be ~$23000. In this model, the data is indeed divided into two parts; with PPP GDP per capita above and below the threshold. Then the impact of CBI on growth is determined in each group.
If the GDP per capita is higher than of ~$23000, central bank independence has a negative impact on growth, whereas for other countries (with PPP GDP below $23000) the impact of central bank independence on growth is positive.
|Population growth rate||-0.985||0.546||0.075|
|Threshold impact of CBI on economic growth|
|Countries below the threshold (GDPPC< US$23000)||0.173||0.09||0.926|
|Countries above the threshold (GDPPC ≥ US$23000)||-6.019||-3.37||0.001|
These relationships could be explained through two mechanisms:
- first mechanism is that of monetary discipline: in countries with GDP per capita below the threshold (mostly comprises of poor countries with bad quality institutions and checks and balances), there is always a danger that the central bank will expand the money supply under pressure from the government and/or lobbying interest groups. Greater central bank independence provides a kind of a blocking mechanism for this type of policy.
- the second mechanism is associated with price rigidities and cost-push inflation. Loose monetary policy in this case can alleviate the negative impact of price rigidities on growth by ensuring that actual output approaches potential output levels. If the central bank is too independent, it does not care about output and unemployment, but only about bringing down inflation and stabilising the exchange rates, so there is a negative impact on growth.
This interpretation suggests that all countries, poor and rich, are prone to the second effect, although for poor countries it may be more pronounced, whereas the first effect is extremely important for poor countries, but not for rich countries.
Central bank independence may be good for growth in poor countries due to its benevolent effect on preventing excessively expansionary monetary policy – and thus avoiding ruinous high and hyperinflation – even though it can prevent the kind of moderate inflation that helps to grease the wheels of rigid markets. The poorer the country, the greater the danger of loose monetary policy carried out under pressure from the government bureaucracy.
In rich countries, central bank independence also hurts growth despite its benevolent effect on monetary discipline – in that it prevents too loose monetary policy – and because of its negative effect on the ability of the central bank to conduct anti-cyclical policy, allowing monetary easing when actual output is lower than potential.
The difference with poor countries is that central bank independence is not really needed in rich countries in order to avoid very high inflation and hyperinflation. Even if the central bank is subordinated to the government, there are democratic accountability mechanisms at work that prevent the government from pursuing an irresponsible (too loose) monetary policy.
But the other danger of an unaccountable central bank – one which conducts inflation targeting without any regard for the business cycle – remains real and can hurt economic growth, even if not as heavily as in poor countries because market rigidities are not that as high.
The richer the country, the lower the danger of lax monetary policy, even with a totally dependent central bank, but the danger of too strict monetary policy remains the same, hence the evidence for a negative impact of central bank independence on growth increasing with the rise of per capita income.
Acknowledgement: the author gratefully acknowledges the valuable comments from Professor Victor Polterovich from the Central Economics and Mathematics Institute of the Russian Academy of Sciences who provided insights about the potential presence of a threshold in the model. My especial thanks also goes to Professor Vladimir Popov from the DOC Research Institute, Berlin for his constructive comments.
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