GV478 Essay

Political Determinants of Central Bank Independence

I. Introduction

“In framing a government that is administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place, oblige it to control itself…” – James Madison

Among policy sciences, Central Bank Independence (CBI) holds a considerable repute as a credibility enhancing mechanism in the conduct of monetary policy. In general, CBI is defined as the freedom to conduct monetary policy without direct government or political interference (Walsh, 2005). It is conventionally believed that CBI is an effective means of inflation management. A plethora of empirical and theoretical studies have shown that CBI reforms helped reduced inflationary bias due to time-inconsistency problems inherent in monetary policy and made the inflationary rule credible.

This consensus has consequently led to a significant number of governments to initiate CBI reforms granting their respective central banks more independence in an effort to insulate monetary policy from political opportunism. Since New Zealand granted its central bank independence through the implementation of Reserve Bank Act of 1989, several countries have followed suit. Dauntfeld et. al. (2008) identified 89 countries that implemented CBI reforms for the period 1980-2005.

While the trend towards CBI has increased, there still exists a significant variation in the degree of independence granted central banks across governments. From a benevolent social policy makers’ perspective, this variation is somewhat of a puzzle. As Bernhard et. al (2002) postulated, if CBI reforms provided an optimal solution to time inconsistency problem, it is rational to expect that governments should grant central banks complete independence. These variations then suggest that the decision to