Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Making central banks independent

Many experts believe that central bank independence leads to lower inflation because it should reduce or eliminate the inflation bias (see the earlier section ‘Encountering time inconsistency’). Does the empirical evidence support this proposition? The answer is a qualified yes.

The historical data from the second half of the 20th century show that the degree of central bank independence varies across countries. In some countries, central banks were very independent, in others less so. A good example of a strongly independent central bank is the US, where governors of the Federal Reserve are appointed by the president for 14 years at a time. Furthermore, the president can’t get rid of them if he doesn’t like the way they’re doing their job! Cushy number, eh?

The length of the term combined with the difficulty of removing Federal Reserve governors means that they have a high degree of independence and limited interference from politicians. You’d therefore expect that the US and similarly independent countries (for example, Switzerland, Germany before the euro) would have low levels of inflation compared to countries where

(over the time period in question) central bank independence was very limited (for example, New Zealand, Spain). Indeed, looking at Figure 13-3, this is exactly what you find.


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Figure 13-3: Central bank independence versus inflation rate.

The answer is only a qualified yes, however, because although central bank independence is associated with lower average inflation, this doesn’t prove that central bank independence causes low inflation. Perhaps, for example, countries with low levels of inflation choose to have more independent central banks. Nevertheless, the data combined with the theoretical argument provide a compelling case that central bank independence is good for lowering rates of inflation in an economy.

You may be wondering what impact central bank independence has on economic performance. The answer is no discernable impact on levels of unemployment or economic growth.

So despite the fact that economists are always shouting about how ‘there’s no such thing as a free lunch’, central bank independence may well be one. Independent central banks are able to have low inflation without having to sacrifice on growth or unemployment. Success!