Why do we need independent central banks?

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In recent years, central banks have become more and more independent from government influence. The reason is that we want them to focus on stable monetary policies rather than output expansion or unemployment reduction. But why?

Theoretical and empirical research suggests that central bank independence does indeed lead to less inflationary monetary policies. Empirically, there is a strong relationship (correlation) between inflation and an index indicating the degree of central bank independence.

Theoretically, it is argued that governments try to steer central banks, if they can, towards inflationary monetary policies. The idea is to make more money available for people to spend and, thereby, create an output expansion. It can be shown, however, that the result is not a better economy, but only more inflation.

Interesting questions

• What is central bank independence? Instrument independence versus goal independence.
• What are monetary policy goals? How does independence affect those goals?
• How independent are the European Central Bank or the US Federal Reserve System? What are their monetary policy goals?
• What is time-inconsistency? Why is time-inconsistency a problem for a stability-oriented monetary policy?
• Would it be good to have central banks only interested in inflation control when the economy is suffering from the current credit crisis?

Links & literature

• http://www.federalreserve.gov/
• http://www.ecb.eu/
• http://www.ecb.int/press/key/date/2005/html/sp050623.en.html
• Manfred Gärtner: Macroeconmics, 2^nd edition, (Financial Times Press/Prentice Hall, 2006), ISBN-10: 0273704605 or ISBN-13: 9780273704607 - see chapter 13.

Research proposal

This research can be done at different levels:

1. Description of central bank independence and discussion of monetary policy goals.
2. Empirical study of central bank independence: simple regression analysis.
3. Graphical-theoretical analysis of the time-inconsistency problem (based on a simplified version of the Barro-Gordon model as, for instance, presented in the book by Gärtner).

Do you have questions or want more information about this topic? Send an email to pucofsociety@fm.ru.nl.

This guideline has been created by the Nijmegen School of Management.