Independence of Central Bank (10%) - Free Essay Example

Independence of Central Bank (10%) Central Bank independence is one of the key pre-requisites for effective inflation targeting. Kahn (2009) states that although monetary policy goals must be set by the democratic government, their implementation should be the mandate of the central bank to avoid the time-inconsistency problem or a political monetary policy cycle. This mandate may not be made into a law, but what matters is past credibility and a continued commitment to the goal of price stability. On other hand, Charles Freedman et al (2010) argues that legislating this mandate is important, particularly in emerging economies where there is a history of government control of monetary policy. For example, the government may resort to populist measures and change the target when central bank has to take unpopular steps. This takes away the basic advantage of inflation targeting- anchoring expectations and increasing predictability and credibility (Kahn, 2009). Guy Debelle et al (1998) argues that fiscal policy must not dominate or dictate monetary policy. This means: Very low or no borrowing by government from the central bank Well-developed domestic markets that can absorb public debt (e.g. treasury bills) Broad base of government revenue so that there is minimal dependence on seigniorage revenues In presence of fiscal dominance, fiscal policy based inflationary pressures will reduce the effectiveness of inflation targeting as central banks will be forced to accommodate government demands such as lowering interest rates to aid fiscal goals. To avoid discretion by governments with regards to monetary policy, transparency and strong communication are important in central banks. In South Africa, monetary goals are set by government by setting the target while constitution guarantees instrument-independence of central bank. (Kahn, 2009) Limitations ofInflationTargeting(10%) Limitation in analyzing its effectiveness is since it is difficult to differentiate between the overall impact of general economic reforms and the more specific impact of inflation targeting. Sarwat Jahan (no year) According to CA Sims (2003) à ¢Ã¢â€š ¬Ã…“Inflation targeting may do more harm than good if there is a substantial chance that the central bank cannot in fact control inflationà ¢Ã¢â€š ¬Ã‚ . This implies that in countries with history of inflation control problems, usefulness of inflation targeting may be limited. Alan Bollard (2008) in his speech said that à ¢Ã¢â€š ¬Ã…“Inflation targeting is not an elixir for stabilization. Independence and accountability arrangements for central banking lead to heightened expectations of what monetary policy is actually able to achieve.à ¢Ã¢â€š ¬Ã‚  So, it will not be effective as a standalone policy. A prerequisite for inflation targeting is co-ordination with fiscal policy. Inflation targeting commitment may not be sustainable under certain conditions. In some cases, what may appear as initial success can lead to adverse impact in future, particularly when required fiscal backup is missing. Similarly, if the inflation target projections cannot be supported with credible explanation of how central bank intends to achieve the desired target, it will undermine its credibility and worsen the situation. For example, if central bank is at zero bound of its policy rate and has no room to influence inflation. Thus, Inflation Targeting is therefore not recommended for the Bank of Japan. (CA Sims, 2003). So, every country must assess its economic conditions and determine if ità ¢Ã¢â€š ¬Ã¢â€ž ¢s a suitable policy or if it can be tailored to suit their conditions. For example, in open economies where the exchange rate impacts output and inflation, the effectiveness and implementation of inflation targeting must be carefully analyzed. (Sarwat Jahan) Other Limitations: Central Bank may overlook more pressing issues like unemployment, exchange rate fluctuations and other macroeconomic variables. During financial crisis, inflation targeting, particularly if rule-based, may restrict central bankà ¢Ã¢â€š ¬Ã¢â€ž ¢s ability due to reduced flexibility. Possible instability in case of large supply-side shocks Since inflation targeting success depends on anchored expectations, lack of public support can undermine its effectiveness Monetary policy impacts inflation with a substantial delay (CA Sims, 2003). So, policy decisions are based on projections and unexpected events may hinder achievement the desired target. Although a much debated point, some argue that higher inflation may be good for economy at times and lower inflation may not always imply stability. OptimalInflationRate (5-10%) Currently, there is no consensus among the a various economic researches about the optimal inflation rate. Most economists agree that inflation should not fall below zero since the costs of deflation are high. They, however, disagree about how much à ¢Ã¢â€š ¬Ã‹Å"above zero inflationà ¢Ã¢â€š ¬Ã¢â€ž ¢ should a central bank target. Many central banks, however, have a similar policy: an inflation target around two percent. These include the Federal Reserve (which calls two-percent inflation a à ¢Ã¢â€š ¬Ã…“longer-run goalà ¢Ã¢â€š ¬Ã‚ ), the European Central Bank (which aims for inflation rates à ¢Ã¢â€š ¬Ã…“below, but close to, 2%à ¢Ã¢â€š ¬Ã‚ ), and most other central banks in advanced economies (Laurence Ball, 2014). The criterion to set optimal target will depend on the countryà ¢Ã¢â€š ¬Ã¢â€ž ¢s the monetary transmission mechanism model and on the stabilization objectives of the monetary policy. (Giannoni et al,2003) References: Challenges of inflation targeting for emerging market economies: The South African case. InConference Papers on Challenges for Monetary Policy-makers in Emerging Markets, South African Reserve Bank. Sarwat Jahan: https://www.imf.org/external/pubs/ft/fandd/basics/target.htm Guy Debelle et al: https://www.imf.org/external/pubs/ft/issues/issues15/ Allan Bollard: https://www.bis.org/review/r080731c.pdf Laurence Ball: https://www.imf.org/external/pubs/ft/wp/2014/wp1492.pdf Marc P. Giannoni,Michael Woodford: https://www.nber.org/papers/w9939.pdf https://www.imf.org/external/pubs/ft/fandd/2010/03/pdf/roger.pdf https://www.imf.org/external/pubs/ft/wp/2008/wp08234.pdf https://www.imf.org/external/pubs/ft/wp/2013/wp1321.pdf https://www.bis.org/review/r131205g.pdf https://www.imf.org/external/pubs/ft/sdn/2012/sdn1201.pdf Important Elements for Inflation Targeting for Emerging Economies: Prepared by Charles Freedman and Inci ÃÆ'–tker-Robe https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp026.pdf https://www.nber.org/chapters/c9562.pdf https://www.newyorkfed.org/research/epr/97v03n3/9708part1.pdf https://siteresources.worldbank.org/PGLP/Resources/Session8.pdf https://www.economicshelp.org/blog/5397/inflation/inflation-targetting-pros-and-cons/ Appendix Targeting inflation There are 28 countries that use inflation targeting, fixing the consumer price index as their monetary policy goal. Three other countriesà ¢Ã¢â€š ¬Ã¢â‚¬ Finland, the Slovak Republic, and Spainà ¢Ã¢â€š ¬Ã¢â‚¬ adopted inflation targeting but abandoned it when they began to use the euro as their currency. Country Inflation targeting adoption date Inflation rate at adoption date (percent) 2010 end-of-year inflation (percent) Target inflation rate (percent) New Zealand 1990 3.30 4.03 1 3 Canada 1991 6.90 2.23 2 +/- 1 United Kingdom 1992 4.00 3.39 2 Australia 1993 2.00 2.65 2 3 Sweden 1993 1.80 2.10 2 Czech Republic 1997 6.80 2.00 3 +/- 1 Israel 1997 8.10 2.62 2 +/- 1 Poland 1998 10.60 3.10 2.5 +/- 1 Brazil 1999 3.30 5.91 4.5 +/- 1 Chile 1999 3.20 2.97 3 +/- 1 Colombia 1999 9.30 3.17 2 4 South Africa 2000 2.60 3.50 3 6 Thailand 2000 0.80 3.05 0.5 3 Hungary 2001 10.80 4.20 3 +/- 1 Mexico 2001 9.00 4.40 3 +/- 1 Iceland 2001 4.10 2.37 2.5 +/- 1.5 Korea, Republic of 2001 2.90 3.51 3 +/- 1 Norway 2001 3.60 2.76 2.5 +/- 1 Peru 2002 à ¢Ã¢â€š ¬Ã¢â‚¬Å"0.10 2.08 2 +/- 1 Philippines 2002 4.50 3.00 4 +/- 1 Guatemala 2005 9.20 5.39 5 +/- 1 Indonesia 2005 7.40 6.96 5 +/- 1 Romania 2005 9.30 8.00 3 +/- 1 Serbia 2006 10.80 10.29 4 8 Turkey 2006 7.70 6.40 5.5 +/- 2 Armenia 2006 5.20 9.35 4.5 +/- 1.5 Ghana 2007 10.50 8.58 8.5 +/- 2 Albania 2009 3.70 3.40 3 +/- 1 Sources: Hammond, 2011; Roger, 2010; and IMF staff calculations.