central bank
The Bank of England, UK. (Credit: asiastock/Bigstockphoto.com) (via: bit.ly)

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 histories 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. Greater independence of central banks is also 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 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 for the period of 1970-2015 using fixed effects 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 interaction between CBI and growth would differ across developing and developed countries, some control variables are introduced.

After running the regression for the full sample, the calculations of the full sample regression with the interaction term – a multiple of CBI index and PPP GDP per capita – enables us to determine a threshold level of PPP GDP per capita to be ~$9800.

If GDP per capita is higher than of ~$9800, central bank independence has a negative impact on growth, whereas for poorer countries (with PPP GDP below $9800) the impact of central bank independence on growth is positive.

However, it is not quite clear why CBI has a negative impact on growth for advanced countries; the absence of any impact seems to be more plausible. Nevertheless, when we divide the sample into two parts – with PPP GDP per capita above and below the threshold – the results are the same. The results are presented in the table below.

These relationships could be explained through two mechanisms:

  • The first mechanism is that of monetary discipline: in 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 exchange rates, so there is a negative impact on growth.

retation 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 inflation 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 a 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 a monetary policy remains the same, hence the evidence for the negative impact of central bank independence on growth increasing with the rise of per capita income.

 

You may also be interested in:

Capital conditions to attract the super-rich
Macroeconomic policies for inclusive growth in Southern countries
Will the next economic miracle happen in the Middle East?
The Islamic Caliphate: Undrawn conclusions
Paradoxes of happiness