Independence of Central Bank with Basic Understanding

Independence of Central Bank with Basic Understanding

Independence of Central Bank

Central Bank is a national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.

A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation.

Independence: State of being independent, or self-rule.

Independence of Central Bank

Central bank independence refers to the freedom of monetary policymakers from direct political or governmental influence in the conduct of policy.

Central bank independence (CBI) is usually understood as the central bank’s ability to control monetary instruments. On the other hand, CBI can also be seen as a set of restrictions on the government’s influence on the management of monetary policy by the central bank. CBI has to be likely to happen in countries with histories of high levels of inflation and in more democratic countries. More independent central banks are usually more transparent, which correlates in turn with institutional quality. Greater independence of central banks is also associated with lower levels of inflation.

Many countries have implemented reforms designed to grant their monetary authorities greater independence from direct political influence, but the degree of CBI varies in countries. Central bank independence is usually guaranteed by legislation and the institutional framework governing the bank's relationship with elected officials, particularly the minister of finance.

Types of Central Bank Independence

Stanley Fischer, who was a professor at MIT (Massachusetts Institute of Technology) has defined two different types of independence of central banks: instrument independence, the ability of the central bank to set monetary policy instruments, and goal independence, the ability of the central bank to set the goals of monetary policy.

1. Institutional or Political independence

It refers to independence of central bank from Political Interference or Government Intervention. Political independence depends on institutional relations between CB and Government, it involves procedures to nominate and dismiss the head central bank and role of government officials in governing the central bank.

2. Economic Independence

It refers to CB’s ability to use monetary instrument without any restrictions.

3. Goal independence

The central bank has the right to set its own policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government departments. This increases the transparency of the policy-setting process and thereby increases the credibility of the goals chosen by providing assurance that they will not be changed without notice.