Central bank n Functions of central bank n
Central bank n Functions of central bank n Operations of central bank n Monetary policies n Central bank independence
Central bank (CB) The central bank is the authority responsible for the monetary policy of a country (or of a group of member states). Usually, its primary responsibility is to maintain the currency stability. The first CBs were established in the 17 th century: Bank of Sweden (1688), Bank of England (1694), Bank of France (1800). CBs were set up in two ways: Ø Gaining the role of CB in competition with other commercial banks (Bank of England in 1844, Bank of France in 1848, FED in 1913); Ø Being specially established to perform the role of CB (the majority of CBs, including the National Bank of Romania in 1880). Some CBs: Ø publicly-owned (the majority); Ø privately-owned (The Swiss National Bank and Federal Reserve System); Ø joint-stock capital (Austrian National Bank, Bank of Greece, Bank of Japan).
Central bank – role and goals The CB plays an important role in the financial system and in the economy: Ø CB’ actions affects the interest rates, the amount of credit, and the money supply, all of which have direct impacts on financial markets, aggregate output and inflation. Ø CB acts as a lender of last resort for the banking system during financial crisis. Ø It may also have supervisory powers, overseeing the banking system. Ø CB offers services to the government and other state institutions. CBs have the following main objectives: Ø macroeconomic objectives (relating primarily to the domestic price level and the exchange rate); Ø long-term strategic objectives of financial sector development (development of an effective payments system and other forms of financial infrastructure); Ø microeconomic objectives (prudential supervision of banking activities).
Responsibilities of CB (I) Currency issue: Ø The CB is the only issuer of banknotes and bank reserves it is the monopoly supplier of the monetary base. Ø By virtue of this monopoly, it can set the conditions at which banks borrow from the CB it can also influence the conditions at which banks trade with each other in the money market. Ø So, the first important function is to control money supply. Monetary and exchange rate policy: Ø The main responsibility of the CB is to establish and implement the monetary policy. Ø The primary objective of the monetary policy, in many countries, is to maintain price stability this is the best contribution monetary policy can make to economic growth and job creation. Ø CB is also concerned by the exchange rate stability.
Responsibilities of CB (II) “Bank of the banks”: Ø CB opens accounts to the banks, receives deposits from the banks, offers loans to the banks, makes payments for the banks, offers services etc. Ø CB is “the lender of last resort”, providing funds to commercial banks when they cannot cover a supply shortage, and, thus, CB prevents banks’ failure. Ø In many countries, CB is the prudential supervision authority. “Bank of the government”: Ø CB holds the Treasury’s checking accounts and makes the required payments. Ø CB serves as the government’s agent: receive bids when new securities are offered and provide securities to the purchases and redeem maturing government securities. Financial stability: Ø Financial stability is a state whereby the built-up of systemic risk is prevented.
Responsibilities of CB (III) Ø Systemic risk is the risk that the provision of necessary financial products and services by the financial system will be impaired to a point where economic growth and welfare may be materially affected. Regulation and supervision of payment system: Ø CB ensures well-functioning payment and securities settlement system. Ø CB regulates and oversees the payments in a economy and keeps the participants' accounts in this system. Ø In many countries, payment transactions are handled primarily by the CB. Collection of information and publication of statistics: Ø CBs collect and publish statistical data related to price evolution, monetary policy, monetary indicators, exchange rates, banking supervision, payments, financial stability, balance of payments, international investment position, real economy etc. Ø The data are aggregated in order to ensure the confidentiality of information provided by individual institutions.
Operations of CB Liabilities: Ø Equity and reserves Ø SDR (Special Drawing Rights) allocated by IMF Ø Deposits: overnight and time deposits of commercial banks, Treasury, other CBs and international financial institutions Ø Marketable securities issued Ø Currency issue Ø Loans from other CBs and international financial institutions Assets: Ø Cash and other payment means Ø Monetary gold Ø SDR’s holdings with IMF Ø Loans (to commercial banks and government) Ø Marketable securities held Ø Shares and other equities held Ø Fixed assets
National Bank of Romania The Romania’s CB is National Bank of Romania (NBR), established in 1880. NBR is an independent public institution, being the only institution vested with the power to issue notes and coins to be used as legal tender within Romania’s territory. Pursuant to Law No. 312/2004 on the Statute of the NBR, the primary objective of our CB is to ensure and maintain price stability. The main tasks of the NBR are the following: Ø to define and implement the monetary policy and the exchange rate policy; Ø to authorize, regulate and supervise of credit institutions; Ø to promote and oversee the smooth operation of the payment systems with a view to ensuring financial stability; Ø to issue banknotes and coins as legal tender on the territory of Romania; Ø to set the exchange rate regime and to supervise its performance; Ø to manage the official reserves of Romania.
Monetary policy is the process by which the CB controls: Ø the supply of money, Ø availability of money, Ø and cost of money (interest rate), in order to attain the objectives oriented towards the growth and stability of the economy. Monetary policy consists in the totality of decisions taken by CB in order to influence economic development and to ensure price and exchange rates stability. Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy: Ø an expansionary policy increases the total supply of money in the economy, being used to combat unemployment in a recession by lowering interest rates; Ø a contractionary policy decreases the total money supply, having the goal of raising interest rates to combat inflation (or to cool an overheated economy).
Objectives of monetary policy (I) The goals of monetary policy generally include: Ø economic growth, Ø low inflation, Ø full employment, Ø price stability. But, frequently these objectives are contradictory, because the achievement of one of them may cause the failure of the others. This is the reason why the monetary policy has, usually, its own fundamental objective – price stability. Why? Ø Because the main contribution that monetary policy can make to economic development in the long run is to maintain low inflation: Ø It is generally agreed that low inflation provides a necessary base for sustained economic growth and development.
Objectives of monetary policy (II) FED: the statutory objectives for monetary policy are: Ø maximum employment; Ø stable prices; Ø moderate long-term interest rates ECB: the primary objective – price stability: Ø To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible (this is laid down in the Treaty on the Functioning of the European Union, Article 127 (1); Ø “Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union“; these include inter alia “full employment” and “balanced economic growth”. NBR: the primary objective – price stability: Ø “Without prejudice to the objective of price stability”, the NBR shall also “support the general economic policies in Romania”.
Monetary policy strategies (I) A central feature of monetary policy strategies in all countries is the use of a nominal anchor as an intermediate target to achieve a final goal (price stability). A nominal anchor is a nominal variable that policymakers use to tie down the price level such as the inflation rate, an exchange rate, or the money supply. Reasons for a nominal anchor’ necessity: Ø it can help promote price stability, which most countries now view as the most important goal for monetary policy: Ø it promotes price stability by tying inflation expectations to low levels directly through its constraint on the value of domestic money. Ø it can limit the time-consistency problem, in which monetary policy conducted on a discretionary basis leads to poor long-run outcomes: Ø this problem arises because economic behavior is influenced by what firms and people expect the monetary authorities to do in the future. Ø it is also called the time-inconsistency problem because monetary policy that leads to a good outcome by controlling inflation is not sustainable (and is thus time-inconsistent).
Monetary policy strategies The benefits of price stability are multiple: Ø Improved CB credibility, accountability, and transparency. An explicit target reduces the CB’s incentive to decline on a commitment to low long-term inflation. Ø Higher long-term growth: economic theory and evidence suggest that low long -term inflation encourages employment and economic growth. Ø Under price stability, money can better fulfill its functions as a medium of exchange and a store of value. Ø A price stability target can also reduce the risk of deflation. Price stability objective can be achieved by CBs using two different strategies: Ø Monetary policy strategy based on intermediate objectives (monetary aggregate and exchange rate), final objective being a low and stable inflation rate. Ø Monetary policy strategy based on inflation targeting (inflation targeting).
Monetary targeting (I) During the ’ 70 s many developed countries adopted monetary targeting. During the ‘ 90 s this strategy have been also adopted by several developing countries and Central and European countries. Monetary targeting is a strategy under which the CB observes and targets monetary aggregates. The basic idea is that controlling monetary base (M 0), CB can control money supply, by controlling banks’ reserves. Monetary targeting is based on three main aspects: Ø CB has to rely on information signaled by monetary aggregates evolution. Ø CB announces targeted level of monetary aggregates. Ø CB should have at its disposal a controllable mechanism that would permit to eliminate big and systematic gaps from assigned monetary objectives. Advantages: Ø It enables CB to adjust its monetary policy to focus on domestic considerations.
Monetary targeting (II) Ø It enables the CB to choose goals for inflation that may differ from those of other countries and allows some response to output fluctuations. Ø It can send almost immediate signals to the public and markets about the stance of monetary policy and the intentions of the policymakers to keep inflation under control. Ø It also allow almost immediate accountability for monetary policy to keep inflation low, thus helping to constrain the monetary policymaker from falling into the time-consistency trap. Ø It is easier for CB to control M 0 and M 1 than inflation rate. Disadvantages: Ø The success of this strategy depend on a big if: ü There must be a strong and reliable relationship between the goal variable (inflation) and the intermediate objective (targeted aggregate). Ø The experience of last decades proved that there is no stable and predictable relationship between monetary aggregates and inflation. Ø Broader monetary aggregates (like M 2 and M 3) are less controllable.
Exchange rate targeting (I) Targeting the exchange rate consists in fixing the value of the domestic currency to that of a low-inflation country (called the anchor country). Another alternative is to adopt a crawling target or peg, in which a currency is allowed to depreciate at a fixed rate so that the inflation rate in the pegging country can be higher than that of the anchor country. CB tries to ensure exchange rate stability by varying interest rate and buying or selling foreign currencies on market. Advantages: Ø The nominal anchor of an exchange-rate target directly contributes to keeping inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country. Ø It provides an automatic rule for the conduct of monetary policy that helps mitigate the time-consistency problem. Ø It has the advantage of simplicity and clarity, which makes it easily understood by the public.
Exchange rate targeting (II) Ø CB uses automatic mechanism: depreciating factors cause monetary policy restriction and appreciating factors lead to monetary policy release. Ø CB is characterized by high transparency. Ø Advantage for transition countries aiming disinflation is that exchange rate targeting is good signal for creation of private sector expectations. Disadvantages: Ø The targeting country no longer can pursue its own independent monetary policy and so loses its ability to use monetary policy to respond to domestic shocks: ü Domestic interests are less followed. Ø The shocks to the anchor country are directly transmitted to the targeting country, because changes in interest rates in the anchor country lead to a corresponding change in interest rates in the targeting country. Ø Vulnerability caused by financial crises is higher: Ø Capital controls are necessary to prevent speculative attacks in the capital field. Ø Goal of low and stable inflation seems to be unattainable (difficult to reach).
Exchange rate targeting (III) One solution to the disadvantages of the exchange rate target is the adoption of a currency board, under which: the domestic currency is backed 100% by a foreign currency; the note-issuing authority establishes a fixed exchange rate to this foreign currency; CB stands ready to exchange domestic currency for the foreign currency at this rate whenever the public requests it. A currency board is just a variant of a fixed exchange-rate target in which the commitment to the fixed exchange rate is especially strong because the conduct of monetary policy is in effect put on autopilot, taken completely out of the hands of the CB. Another solution is dollarization, the adoption of a sound currency, as a country’s money, being just another variant of a fixed exchange-rate target with an even stronger commitment mechanism than a currency board provides.
Inflation targeting (IT) Some CBs found the traditional approaches – influencing inflation and economic activity by controlling intermediate variables (monetary aggregates or an exchange rate) – not very successful. these CBs faced the serious possibility of losing their credibility. To solve this problem, several industrialized countries adopted monetary policy strategy that target inflation directly: New Zealand (1990), Canada (1991), the United Kingdom (1992), Australia (1993), and Sweden (1993). Over the past decade some emerging-market economies adopted the IT : Brazil (1999), Chile (1999), Mexico (2001), Norway (2001), Peru (2002), Philippines (2002), South Africa (2000), Spain (1995), Thailand (2000), Turkey (2002) etc. This policy has also been adopted by Central and Eastern economies – the Czech Republic (1997), Hungary (2001), Poland (1998) and Romania (2005). In all these countries inflation rate has decreased after the adoption of this strategy.
Concept of IT represents a framework of policy decisions in which the CB makes an explicit commitment to meet a publicly announced numerical inflation target within a particular time frame. IT is characterized by five key elements: Ø the public announcement of medium-term numerical targets for inflation; Ø an institutional commitment to price stability as the primary goal of monetary policy; Ø a strategy that comprises not just monetary aggregates or the exchange rate but also many variables used for establishing the policy instruments; Ø increased transparency of the monetary policy strategy through communication with the public and the markets about the objectives, and decisions of the CB; Ø increased accountability of the CB for attaining the inflation targets. Many authorities make a public announcement of numerical target for inflation, but that does not mean that they apply IT, because the other four elements are required for IT to be sustainable over the medium term.
Requirements for IT CB should have a considerable degree of independence. CB should not be constrained to finance the government budget. CB should renounce from targeting the level of any other nominal variable. CB must have an effective monetary policy instrument. Transparency and accountability of the CB are essential to anchor inflationary expectations. CB must possess the ability to forecast inflation. Country adopting inflation targeting has to select the relevant price index that is to be targeted. Inflation targeting framework should be forward looking as any monetary policy action has a lagged effect. Adopters of IT should apply a flexible exchange rate mechanism.
Motivation for adopting IT 1. 2. 3. 4. The experience of ‘ 70 s and ‘ 80 s indicated that high inflation could not support sustainable growth, external competitiveness or employment: the primary contribution of CBs to good economic performance is to create a favourable framework for maintaining inflation at a low level. The innovation in financial products and financial markets make the monetary aggregates less reliable predictors for the prospected evolution of inflation: the main reason for the adoption of IT by the developed countries was the unstable relation between monetary aggregates and inflation in the short term. The monetary policy has undergone important changes under the impact of international integration of financial markets and capital flows liberalization: several countries replaced the fixed exchange rate system with a flexible one, since it could protect better the domestic economic from the external shocks. IT proved to be a successful strategy in granting flexibility and credibility to the monetary policy: better performance of inflation and economy, a higher adaptability to shocks.
Advantages of IT enables monetary policy to focus on domestic considerations and to respond to shocks to the domestic economy. The stability in the relationship between money and inflation is not critical to its success, because it does not rely on this relationship. An inflation target allows the monetary authorities to use all available information, not just one variable, to determine the best settings for monetary policy. It is readily understood by the public and is thus highly transparent. It has the potential to reduce the likelihood that the CB will fall into the timeconsistency trap, trying to expand output and employment by pursuing excessively expansionary monetary policy. It can help focus the political debate on what a CB can do in the long run (control inflation) rather than what it cannot do (permanently increase economic growth and the number of jobs through expansionary monetary policy). II put great stress on making policy transparent and on regular communication with the public.
Disadvantages of IT Delayed Signaling: Ø Inflation is not easily controlled by the monetary authorities. Ø Because of the long lags in the effects of monetary policy, inflation outcomes are revealed only after a substantial lag. Ø Thus, an inflation target is unable to send immediate signals to both the public and markets about the stance of monetary policy. Too Much Rigidity: Ø IT imposes a rigid rule on monetary policymakers, limiting their discretion to respond to unforeseen circumstances. Potential for Increased Output Fluctuations. : Ø A single focus on inflation may lead to monetary policy that is too tight when inflation is above target and thus may lead to larger output fluctuations. Low Economic Growth: Ø It will lead to low growth in output and employment. Ø But once low inflation is achieved, IT is not harmful to the real economy.
IT and economic performance Many studies have found that IT improves the performance of inflation and output and improves inflation forecasting by lowering the expected level of inflation and/or increasing its predictability. By contrast, an almost equal number of studies claim not to find clear evidence to support the benefits of IT, though their results do not provide arguments against IT either. However, IT framework might promote weakly performing countries to “converge” to those countries performing better already. The evidence confirms that the adoption of this policy has permitted inflation targeters to reduce inflation to low levels. IT appears to have provided a successful nominal anchor for conducting monetary policy in the countries that have adopted it so far. The strongest evidence in this sense is that, thus far at least, none of the several dozen adopters of IT has abandoned the approach.
IT in Romania NBR have adopted IT in 2005, having the following features: § inflation targets specified in terms of CPI (headline inflation); § inflation target set as a midpoint within a target band of +/-1 percentage point; § announcement of annual inflation targets for longer time horizons (initially two years); § maintenance of a managed float exchange rate regime; § ex ante definition of a few “exemptions” ("exceptional circumstances") that are out of the control of monetary policy and thus limit the responsibility of the NBR for achieving the announced inflation targets; § joint formulation and announcement of inflation targets by the NBR and the government. § computing the core inflation by NBR for analytical purposes: Ø CORE 1 = CPI – administrated prices; Ø CORE 2 = CORE 1 – highly volatile prices; Ø Adjusted CORE 2 = CORE 2 – tobacco and alcohol prices.
IT in Romania NBR have adopted IT in 2005, having the following features: § inflation targets specified in terms of CPI (headline inflation); § inflation target set as a midpoint within a target band of +/-1 percentage point; § announcement of annual inflation targets for longer time horizons (initially two years); § maintenance of a managed float exchange rate regime; § ex ante definition of a few “exemptions” ("exceptional circumstances") that are out of the control of monetary policy and thus limit the responsibility of the NBR for achieving the announced inflation targets; § joint formulation and announcement of inflation targets by the NBR and the government. § computing the core inflation by NBR for analytical purposes: Ø CORE 1 = CPI – administrated prices; Ø CORE 2 = CORE 1 – highly volatile prices; Ø Adjusted CORE 2 = CORE 2 – tobacco and alcohol prices.
Monetary policy with an implicit nominal anchor Recently, many developed countries have achieved excellent macroeconomic performance (including low and stable inflation) without using an explicit nominal anchor (exchange rate, a monetary aggregate, or an inflation target). As emphasized by Milton Friedman, monetary policy effects have long lags. The presence of long lags means that monetary policy cannot wait to respond until inflation has already present. If the CB waited until obvious signs of inflation appeared, it would already be too late to maintain stable prices, at least not without a severe tightening of policy. To prevent inflation from getting started, therefore, monetary policy needs to be forward-looking and pre-emptive: Ø depending on the lags from monetary policy to inflation, monetary policy needs to act long before inflationary pressures appear in the economy. For example: if it takes about two years for monetary policy to have a significant impact on inflation, even if inflation is currently low, the policymakers must now tighten monetary policy to prevent it.
Monetary policy tools CB can use 2 types of monetary policy tools: Ø Indirect tools: Ø open market operations Ø reserve requirements Ø monetary policy interest rate; Ø Direct tools: Ø directing credit – governments may attempt, through their CBs, to encourage private investment in what they regard as priority activities; Ø ceiling credit – governments may attempt, through their CBs, to establish an upper limit of the volume of credits granted by the banks. At the present, majority of CB uses exclusively indirect tools. Ø ECB and NBR: open market operations, standing facilities, reserve requirements. Ø FED: open market operations, discount window lending, reserve requirements.
Open market operations (I) In a broad sense, five types of instruments are available to the CB for the conduct of open market operations (all are initiated by CB): 1. reverse transactions (applicable on the basis of repurchase agreements or collateralized loans): are the most important instrument; are operations through which CB buys and sells government securities from/to commercial banks, having the following effects: Ø when CB buys securities, the liquidity in banking system will increase and interest rate will decrease (repo operations) Ø when CB sells securities, the liquidity in banking system will decrease and interest rate will increase (reverse repo operations). 2. outright transactions – CB sells/buys eligible assets whose ownership is transferred from seller to buyer on a “delivery versus payment” basis; 3. issue of debt certificates – CB sells certificates of deposit to banks.
Open market operations (II) 4. foreign exchange swaps – consist of two simultaneous transactions concluded with the same counterparty, whereby the CB: buys foreign currency spot against domestic currency, for liquidityproviding purposes, and sells at a later date the same amount of foreign currency forward against domestic currency; sells foreign currency spot against domestic currency, for liquidityabsorbing purposes, and buys at a later date the same amount of foreign currency forward against domestic currency. 5. collection of fixed-term deposits – CB takes deposits from banks. Open market operations play an important role in the monetary policy of the CB for the purposes of : Ø steering interest rates, Ø managing the liquidity situation in the market, Ø signaling the stance of monetary policy.
Open market operations (III) Open market operations are initiated by the CB, which also decides on the instrument to be used and on the terms and conditions for its execution. They can be executed on the basis of: Ø standard tenders, Ø quick tenders or Ø bilateral procedures. Open market operations are conducted simply by electronically increasing or decreasing (‘crediting’ or ‘debiting’) the amount of money that a bank has in reserve account at the CB): If the CB buys financial assets (such as government securities) in the open market, the amount of money that the selling bank holds increases, and, thus, the money supply increases. If the CB sells assets in the open market, the amount of money that the purchasing bank holds decreases, effectively destroying money, and money supply decreases too.
Standing facilities in Euro zone Standing facilities are aimed at: Ø providing and absorbing overnight liquidity, Ø signal the general stance of monetary policy Ø and bound overnight market interest rates. Two CB can offers credit institutions two standing facilities: Ø marginal lending facility in order to obtain overnight liquidity from the CB against eligible assets (the marginal lending rate is 0. 25% in euro zone, and 3. 25% in Romania); Ø deposit facility in order to make overnight deposits with the CB (the deposit facility rate is -0. 4% in euro zone and 0. 25% in Romania). The interest rates on the marginal lending and deposit facilities normally provide a ceiling and a floor for the overnight market interest rate.
FED’s lending facilities – the discount window In USA, Federal Reserve System offers depository institutions 3 types of credit through discount window lending programm: Primary credit is a lending program available to sound financial depository institutions; it is available on a very short-term, (typically overnight), at a rate set above the usual level of short-term market interest rate * (at present 1. 5%) Secondary credit is available to depository institutions that are not eligible for primary credit; it is extended typically overnight, at a rate set above the primary credit rate (at present 2%) Seasonal credit program assists small depository institutions in managing significant seasonal fluctuations in their loans and deposits; discoun rate for seasonal credit is an average of selected market rates (at present 1. 0 %) * Federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight (around the target established by the FOMC – at present set 0. 75% - 1%; at present the effective federal funds rate is 0. 91%).
Monetary policy interest rate It is the interest rate that the CB charges banks for short-term loans. Increases in the monetary policy interest rate reflect the CB’s concern over inflationary pressures, while decreases reflect a concern over economic weakness: Ø If CB increases the monetary policy interest rate, this will slows economic activity and allows the control of inflation; Ø If CB decreases the monetary policy interest rate, this will stimulates the economic activity and supports economic growth. For example, monetary policy interest rate is: Ø in USA: discount rate – rate charged for primary credit (the primary credit is the Federal Reserve’ main discount window program) (at present 1. 5%); Ø in euro zone: interest rate on main refinancing operations (regular liquidityproviding reverse transactions with a frequency and maturity of one week) - at present 0. 0%. Ø in Romania: interest rate on repo operations with a maturity on one week, (liquidity-providing reverse transactions (at present, 1. 75%).
Minimum reserve requirements (I) Reserve requirements are the amount of funds that a depository institutions must hold in their own deposit at CB against specified deposit liabilities. Usually, the CB has the authority over changes in reserve requirements. Reserve requirements have two functions: Ø Buffering: holding funds on account with the CB provides a buffer against liquidity shocks. Ø Create a liquidity deficit: holding funds on account with the CB decreases the banks’ funds available for offering loans, reducing the money creation (MS). The minimum reserve system primarily aims to stabilize money market interest rates and creating a liquidity shortage: Ø If CB increases the reserve ratio, the lending activity will be slowed down and the cost of credit (interest rate) will rise, because the banks will have less financial resources for granting loans. Ø If CB decreases the reserve ratio, the lending activity will be stimulated, because the banks will have more financial resources for granting credits.
Minimum reserve requirements (II) Reserve ratios are: Ø Euro zone: 1% for overnight deposits, deposits with a maturity of up to 2 years, debt securities issued with maturity up to 2 years, money market paper. Ø USA: are applied to transaction deposits, but varying depending on the amount: § 0% for amounts less than 15. 5 mil. ; § 3% for amounts between 15. 5 and 115, 1 mil. ; § and 10% for amounts higher then 115. 1 mil. Ø Romania: 8% for domestic currency denominated deposits and 8% foreign currency denominated deposits Required reserves can be remunerated or not: in the euro area they are remunerated at the rate of the Eurosystem’s main refinancing operations (which is 0. 0%); in Romania at the average interest rates applied by banks for demand deposits. in USA required reserve balances are remunerated at a rate of 1%.
Central bank independence It is generally accepted that CBs are most effective in maintaining low inflation and in performing their other proper functions when they are independent of government. Central bank independence (CBI) refers to the freedom of monetary policymakers from direct political or governmental influence in the conduct of monetary policy. Practical experience has demonstrated that elected officials may be motivated by short-run electoral considerations or may value short-run economic expansions highly while ignoring the longer-run inflationary consequences of expansionary policies. If the ability of elected officials to distort monetary policy results in excessive inflation, then countries whose central banks are independent of political pressure should experience lower rates of inflation.
Definition of CBI Concerning the meaning of CBI, Grilli, Masciandaro, and Tabellini (1991) have made a basic distinction between “political” and “economic” independence: Ø Political independence: the ability of the CB to determine its policy objectives free from the government’s influence. Ø Economic independence: the ability of the CB to determine and implement its policies towards the achievement of its objectives. The more common terminology is due to Debelle and Fischer (1994), who made a distinction between goal independence and instrument independence: Ø Goal independence: CB’s ability to determine the goals of the policy without the direct influence of the fiscal authority. Ø Instrument independence: CB’s ability to freely adjust its policy tools in pursuit of the monetary policy goals.
Achievement and measurement of CBI Achievement of CBI: Ø CB can enjoy independence from the government in outlining its monetary policy. Ø CB’s governor is not to be appointed by the government and his term in office will be long and irrevocable. Ø Price stability will be stipulated in the statute of the CB as a primary objective and possibly as the single objective. Ø There are limitations on the government’s ability to borrow funds from the central bank in order to finance its budgetary deficit. All these measures lead to the conclusion that the more a CB avoids political interference, the more independent it becomes. Measurement of CBI: Ø an index of legal CBI considering legal characteristics of CBs; Ø an index of actual CBI based on governor’s turnover rate.
CBI and economic variables CBI and inflation: Ø Several researches have provided empirical support for the negative relationship between CBI and inflation in industrial and developing countries. Ø Some studies have shed doubt on the strength of this negative correlation. Ø Despite these contradictory conclusions, it is generally believed that a high degree of CBI reduces the inflationary bias of policy and enhances the credibility of stable monetary policies. CBI and real economic variables: Ø Some studies argue that real growth and CBI are unrelated in developed economies. Others indicate that turnover rate of CB governors is negatively associated with economic growth in developing countries. Ø Some researchers have not found any correlation between CBI and interest rates or between CBI and unemployment. Others have proved that variability of interest rates is negatively associated with legal CBI. Ø Some studies show that employment decreases in the case of CBI.
Independence of NBR Law 312/2004 regarding the statute of the NBR confers it a high degree of independence: Ø The primary objective of NBR is to secure and maintain price stability. Ø In the accomplishment of its responsibilities, NBR and the leadership members will not demand or receive instructions from public authorities or from any other institution. Ø Board members are appointed by the Parliament for a five-year renewable term. Ø The Parliament is entitled to dismiss a Board member if the official in question does not meet the requirements for exercising certain prerogatives or if he/she is guilty of misconduct. Ø According to an express provision of the Maastricht Treaty, the CB cannot acquire government securities from the primary market. Ø The law also bans the NBR from granting overdraft or any other type of credit to the state, central and local authorities, and other enterprises in which the state has a stake.
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