American Economic Association

Central-Bank Independence Revisited Author(s): Stanley Fischer Source: The American Economic Review, Vol. 85, No. 2, Papers and Proceedings of the Hundredth and Seventh Annual Meeting of the American Economic Association Washington, DC, January 6-8, 1995 (May, 1995), pp. 201-206 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2117919 Accessed: 30/04/2010 00:14
Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review.

http://www.jstor.org

Central-BankIndependence Revisited
By STANLEY FiSCHER*
The case for central-bankindependence (CBI), while not a new one, has been strengthened a growingbody of empirical by evidence, by recent developments in economic theory, and by the temper of the times. The case is a strong one,1 which is becoming part of the Washington orthotributes the inflationarybias either to the dynamicinconsistency monetarypolicy in of an expectational Phillips-curve model of or output determination to the revenuemotive of the inflation tax, in a context in which the fiscal authorityweights the social costs of inflation inappropriately,or to doxy. both.3 The purposes of this paper are both to The two main strandsof theorythat have make more precise the type of CBI that is added precision to the analytic argument likely to enhance economic performance, for CBI are the conservative-central-banker and to point to some remainingopen issues approachof KennethRogoff(1985),and the and anomalies.I startwith the two theoreti- principal-agent approach of Carl Walsh (1995) and Torsten Persson and Guido cal approachesto CBI. Tabellini (1993). In the Rogoff approach, I. The Theoretical Basis the social-lossfunctionweightsdeviationsof for Central-Bank both output and inflationfrom optimal levIndependence els, and dynamic inconsistency produces The modern case for CBI begins from the higherinflationthan is sociallyoptimal.This inflationary bias that would otherwise be loss can be reduced in multiperiodmodels present in monetary policy. That there has in which the central bank is allowed to at times been such a bias in practice can be develop a reputation. It can also be reconcluded from the high inflation rates of duced, as Rogoff points out, by entrusting the 1970'sand early 1980'sin most industri- monetarypolicy to a person or institution alized countries. Other examples of infla- who weights inflationdeviationsmore heavtionarybias can be found in multidigitan- ily than in the social-welfarefunction-the nual inflation rates in both industrialized conservativecentral banker.This results in and developing countries, most spectacu- improvedoverall performance,in which inModern theory atflation is on averagelower and more stable larly in hyperinflations. than with a less conservative centralbanker, but output is more variable. In the alternative principal-agent approach, the inflationary-biasproblem is * InternationalMonetary Fund, 700 19th Street, solved by structuringa contract that imN.W., Washington,DC 20431 (on leave from MIT), poses costs on the central bankerwhen inand ResearchAssociate, NBER. I am gratefulto the discussants,MichaelBruno,Donald Kohn, and David flation deviates from the optimal level. As Mullinsfor helpfulcomments. The viewsexpressedare Walsh (1995) shows, the inflationpenalty is those of the author and should not be interpretedas
those of the IMF. 1The argumentsfor CBI are reviewed and developed at greater length in Fischer(1994), and applied for there to supportthe case for greaterindependence the Bankof England.For a completeexpositionof the modern approachup through1992, see Alex Cukierman (1992). 2JohnWilliamson's of (1990) description the Washington consensus does not explicitlyinclude CBI. A mid-1990's versionwould do so.
201

bias 3Inflationary is not inevitable:there have been episodes in the past, such as at the time of Britain's returnto gold in 1925,and duringthe downturn phase of the Great Depression in the United States, when centralbankssufferedfrom a deflationary bias.

202

AEA PAPERS AND PROCEEDINGS

MAY 1995

linearin inflationin the standardmodel and is thus conceptuallyeasy to design. Both approacheshave the smell of realism. The conservativecentral banker is a familiar type, encountered in his or her anti-inflationary speeches all over the world. In this interpretation,the central bank has to be independentto ensure that its preferences rather than those of society determine monetarypolicy in a context in which precommitmentto optimal (low-inflation) policy is impossible. At the same time as central bankersdenounce inflation,they in practice take into account the short-run trade-off between inflation and output in deciding on the speed at which to reduce inflation when it is (or is expected to be) above target levels, and the speed at which to reflatefrom a recession.They thus satisfy the Rogoff (1985) model's assumptionsthat the conservativecentral bankerweights deviations of both inflation and output from target levels in setting monetarypolicy. The principal-agent approach has been implemented in New Zealand, where the Governorof the Reserve Bank agrees on a target inflation path with the government, with his job on the line if he fails to achieve the targets. Prespecifiedadjustmentsto the targetinflationrate are made for changesin the terms of trade and indirecttaxes. Other countries in which the central bank has a clearly spelled-out inflation contract with the government,such as Canada and, recently, the United Kingdom, can also be thought of as pursuingthe principal-agent approach,provided the penalty for excess inflation is interpreted(realistically)as the central banker's loss of reputation. There are also elements of the principal-agent approachin all countrieswhere the central bank has reasonablyclearly defined goals, such as in Germanywhere the Bundesbank is given the task of safeguardingthe currency. These two approachespoint to different forms of CBI. Guy Debelle and Fischer (1995) and Fischer(1995) introducethe distinction between goal independence and instrument independence. A central bank that

a ment independence; central bank that sets its own policy goals has goal independence. In the Rogoff (1985) approach,the central bankeris givencontrolover monetarypolicy and the independence to maximize his or her own utility function: he thus has both goal and instrument independence. Of course, the governmenttries to choose the right centralbanker,but-as in the case of Supreme Courtjustices-the behaviorof a central banker may be different after appointmentthan before. The central banker in the principal-agentapproachhas no goal independencebut does have instrumentindependence.4 In a well-defined sense, the central banker in the principal-agent frameworkis held accountablefor the outcome of monetarypolicy, in that there are definite consequences of failing to achieve well-specifiedgoals. The most important conclusion of both the theoretical and empiricalliteraturesis that a central bank should have instrument independence,but shouldnot have goal independence.5 Rather, the central bank shouldbe given a clearlydefinedgoal or set of goals, and the power to achieve them, and should be held accountablefor doing so.6 Accountabilityis needed for two reasons: first, to set incentivesfor the central bank to meet its goals and explain its actions; and second, to provide democratic oversightof a powerfulpolitical institution. Formsof accountability differ,with the New Zealand model making the Governor accountableto the Finance Ministerin a pre-

is given control over the levers of monetary policy and allowed to use them has instru-

4The distinction between goal and instrument independence helps make sense of the apparent anomaly that at the same time as CBI is gaining academic and policy support, so once again are nominal exchange-rate pegs. A central bank with the task of maintaining an exchange-rate peg has no goal independence; it may or may not have instrument independence, depending on how tightly specified are the constraints placed on it in creating credit. 5The basis for these conclusions is laid out in Fischer (1995). 60f course, central banks cannot achieve targets exactly, and there is need both to specify ranges for target variables and a reasonable procedure for adjusting the targets in response to shocks exogenous to the central bank.

VOL. 85 NO. 2

HOWINDEPENDENT SHOULD THE CENTRAL BANK BE?

203

cise way, the U.S. model making the Fed a narrow monetary aggregate;whether to generally but not precisely accountable to choose an exchange-ratepeg instead of an the Congress,and the Germanmodel mak- inflationtarget;why inflationshould be the ing the Bundesbank accountableto the pub- sole target given that monetary policy aflic. Given the importanceof reputation to fects both output and inflation in the short in individuals publiclife, each approachmay run, and the related question of whether to work;nonetheless, precise accountability to specifya nominalincome target ratherthan elected officialsis more likelyto be effective an inflationtarget;and whetherto choose a than vague general accountability. price-level rather than an inflation-rate tarInstrument independenceimpliesthat the get. central bank should be free of any obligaObviouslyit would be best for the central tion to finance governmentbudget deficits, bank to target a policyvariabledirectlyundirectlyor indirectly,7 and should have the der its control that also closely controls an power to determine interest rates. The ultimate target variable, such as the inflaquestionof whetherthe centralbank should tion rate or output. For some time, the supervisebanks remainsopen, but it is not hope was that monetary targeting would of much importance.Interestingly, pow- achieve that purpose, but as the relationthe ers of the central bank to set the exchange ship between money growth and inflation rate are typicallylimited, even for the more and/or output has broken down in one independentcentral banks:the government country after another, it has not proved generally retains the power to determine possible for any country to rely solely on the choice of the exchange-ratesystem; in monetarytargeting.9In any case, the cenfixed-rate systems, the decision to devalue tral bank should be left to decide whether and the new parity are usuallythe primary monetarytargetingis useful for meeting its of responsibility the financeministry,which ultimate goals. One reason for having a is shared with the central bank; within a centralbank is to centralizeboth the capacflexible exchange-ratesystem, if the central ity and the responsibilityfor figuring out bank has the right to determine interest how best to implementmonetarypolicy. rates, it will also have the rightto determine This is not the place to go into the details the exchangerate. of the merits of fixed versus floating exchange rates. Nominal-exchange-rate pegs II. Inflation-Targeting may be useful as a means of anchoring monetarypolicy and expectationswhen atAs support for CBI has strengthened,so tempting to stabilize from high inflation. has the tendencyto set the centralbank the They may also be useful in small open sole task of achieving a targeted inflation economies,or in economieswhere the monrate or range.8Typicallythe inflationtarget etaryauthorityhas lost credibilityand needs is for an inflation range over the next year to regain it. Sometimes,as in the European or two, or else for a path of inflation(also Union, an exchange-ratepeg may in addiwithin a range) over several years. The tion reflect a political commitment.It is of choice of an inflation target raises several course also possible that the monetaryauissues: whether it would not be better to thoritychooses both an inflationtarget and choose a targetthat is more directlycontrol- an associatedexchange-rate or path, as peg lable by the centralbank, such as growthof in a crawling-pegsystem. The choice between an exchange-rate and an inflation peg
7However, the central bank may help the treasury in its short-term cash management operations. 8Indeed, some researchers measure CBI by the extent to which the central bank is assigned the sole goal of price stability or low inflation (see Cukierman, 1992 Ch. 19).

9There is nothing more common after a money demand function appears to have broken down than the demonstration that the demand for some other definition of money was stable. These ex post exercises are not impressive.

204

AEA PAPERS AND PROCEEDINGS

MAY1995

target, or any other nominal anchor,has to be determined on the basis of the history and structure of each economy. Whatever the choice, monetary policy under an exchange-ratepeg is not automatic,except in a strict currency-board system (see Steve Hanke and Kurt Schuler, 1994), and the central bank has to take into account the long and variable lags of policy and deal with the difficultiescaused by capital movements in setting interest rates and credit conditions. One likely answerto the question of why monetary policy should target inflation ratherthan nominalGDP is that inflationis a monetaryphenomenon.This is better poetry than economics.In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run-albeit with long-runtargets and consequences in mind. Nominalincome-targeting providesan automaticanswer to the questionof how to combinereal income and inflation targets, namely, they shouldbe tradedoff one-for-one.There are two main difficultieswith nominal-incometargeting: first, and more fundamentally, nominal GDP data appear with a lag and are frequentlyrevised; and these data appear to be of little direct interest to the public. The data-revisionproblem is a severe one. The case for inflation-targetingrather is than nominal-income-targeting that the inflation rate is of direct concern to economic agents, and that inflation performance is easier to monitor than nominalincome performance. Inflation-targeting gives the right monetary-policy response to demandshocks,namely,that monetarypolicy shouldbe tightenedin responseto shocks that would tend to increaseboth output and inflation. Because a supply shock leads to higher prices and lower output, monetary policywould tend to tightenless in response to an adverse supply shock under nominalthan it would under inflaincome-targeting tion-targeting." Thus nominal-income-

targetingtends to imply a better automatic response of monetary policy to supply shocks. This advantageis offset to the extent that inflation-targeting makes special provision for supply shocks: for instance, the New Zealandinflationtargetis adjusted for terms of trade shocks, and inflationtargets in several countries adjust in a variety of ways to deal with the impact of indirect taxes. I judge that inflation-targetingis preferable to nominal-income-targeting, provided the target is adjusted for supply shocks. Finally,should the target be a price-level path rather than an inflation-rate path? When policy targets a price-level path, it has to offset past inflationaryshocks by a period of below-averageinflation,in order to returnto the targetedpath. As shown in Fischer (1995), inflation-targeting tends to producemore certaintyaboutthe price level in the near future, at the expenseof greater uncertaintyabout the price level in the distant future. Equivalently,the inflationrate would fluctuatemore in the shortrun under price-level-targeting,as policy strives to come back to the chosen price path. For instance, under price-level-targeting,the Bundesbank, at the end of 1994, would be requiredto reduce inflationbelow its 2percent target range for as far and as long as it takes to undo the effects of the aboveaverageinflationof the period since 1990.If the goal is to encouragelong-termnominal then price-level-targeting would contracting, be preferable.However,since the greatbulk of nominal contracts are relatively shortterm, since the task of monetary policy would be made much more demandingunder price-level-targeting, since the benand efits of long-term nominal contractingare equivalentlyobtained by permittingindexation, inflation-targetingis preferable to price-leveltargeting.
III. OpenIssues

100f course, the extent of monetary tightening under the two rules would depend on the decisions of the monetary authority.

The most impressivesingle empiricalresult in the CBI literatureis the well-known chart showing that, among industrialized countries, average inflation performanceis negatively related to the degree of legal independenceof the central bank (see e.g.,

VOL. 85 NO. 2

HOWINDEPENDENT SHOULD THE CENTRAL BANK BE?

205

Alberto Alesina and Lawrence Summers, 1993). One reaction, for example by Adam Posen (1993), is that the relationshipis not causal. Rather, countries that are in effect inflation-aversedevelop the institutions to support that aversion.In particular,Posen argues that countriesin which the financial sector is politicallypowerful,become effecThis certainlyfits the tively inflation-averse. but case of Switzerland, hardlyBrazil,where the profits the financialsector made out of inflationwere a key element in the political In difficulty stabilization. any case, unless of laws are totally irrelevantto performance, anyone wanting to reduce inflation would still be well advised to supportactivelythe cause of CBI. There are several anomalous empirical the resultsin the CBI literature,particularly finding reported in Cukierman(1992) that the basic negative relationshipbetween legal independenceand averageinflationdoes not hold for a groupof 72 developingcountries for which data were assembled;rather the relationshipis positive.Among the possible explanations are that the law is not observed in some countriesor that key aspects of independence(e.g., the provisionof instrumentindependence by insulatingthe central bank from the requirementto finance the governmentbudget) are absent. Another interestingempiricalresult is the apparent free lunch provided by CBI in countries(this point has been industrialized and Eric emphasizedby SylvesterEijffinger Schaling[1993]).Not only is CBI negatively associatedwith inflation,it also apparently has no costs in terms of growth; further, both the variance of inflationand the variance of output growthappearon averageto be lower for countriesthat have more-independent central banks. These results are not at first glance consistent with the predictions of the Rogoff (1985) model, which implies that centralbankstrade off between output and inflation variability.At least three explanationssuggest themselves:first, that more-independent central banks are better at stabilization than less-efficient banks, and therefore come closer to the frontier; that fiscal stabilization-efficiency policy is more disciplinedin countrieswith more CBI; and that both inflationand out-

put performanceare primarilyaffected by shocks that differfrom countryto country. At a broaderlevel, the question arises of why the political systemshould shield monetary but not fiscal or other economic policies from political pressures.The answeris that there are good reasons to attempt to shield fiscal policy from certain populist pressures and from dynamicinconsistency: many systems prohibit ex post tax changes (despite the efficiencyof lump-sumtaxes); capital taxation is restricted in some conor texts; and balanced-budget deficit-limitation laws are widely discussed and sometimes implemented. The trick is to attain the appropriatebalance between the need to be responsive to short-term pressures and the need to ensure that those pressures are exerted in a system that safeguardsthe long-terminterestsof the population. Finally,there is the questionof whethera central bank can be too independent.The answeris yes. As a matterof theory,both of the basic analyticmodels of centralbanking imply that the central banker can be too inflation-averse,and too insensitive to the possibilities of stabilizing output. Further, there are potentialbenefitsfrom the coordination of monetary and fiscal policy that may be forgone when the central bank is independent. Central-bank accountability, throughthe structureof the board, through reportingto and questioningby elected officials, and through the provision of information to and effective receptivityto criticism from the informedand general public, is thereforeessentialif monetarypolicyis to be both shielded from inappropriate political pressuresand sensitiveto the real needs of the public.
REFERENCES
Alesina, Alberto and Summers, Lawrence H.

and "Central Bank Independence Performance: Some Macroeconomic Comparative Evidence." Journal of Money, Credit, and Banking, May 1993, 25(2), pp. 151-62. Alex. Central bank strategy, crediCukierman, bility, and independence. Cambridge, MA: MIT Press, 1992.

206

AEA PAPERS AND PROCEEDINGS

MAAY 1995

Debelle, Guy and Fischer, Stanley. "How Inde-

pendent Should a Central Bank Be?" in Federal Reserve Bank of Boston conference volume, 1995 (forthcoming).
E"ffinger, Sylvester and Schaling, Eric. "Central

Bank Independence: Theory and Evidence." Mimeo, Tilburg University, February 1993. Fischer, Stanley."Modern Central Banking," in Forrest Capie, Stanley Fischer, Charles Goodhart, and Norbert Schnadt, eds., The future of central banking. Cambridge: Cambridge University Press, 1995 (forthcoming), pp. 262-308.
Hanke, Steve H. and Schuler, Kurt. Currency

boards for developing countries: A handbook. San Francisco, CA: ICS Press, 1994.
Persson, Torsten and Tabellini, Guido. "Design-

ing Institutions for Monetary Stability." Carnegie-Rochester Conference Series on

Public Policy, December 1993, 39, pp. 53-84. Posen, Adam. "Central Bank Independence Does Not Cause Low Inflation: The Politics Behind the Institutional Fix." Mimeo, Harvard University, December 1993. Rogoff, Kenneth. "The Optimal Degree of Commitment to an Intermediate Monetary Target." Quarterly Journal of Economics, November 1985, 100(4), pp. 1169-90. Walsh, Carl. "Optimal Contracts for Central Bankers." American Economic Review, March 1995, 85(1), pp. 150-67. Williamson,John. "What Washington Means by Policy Reform," in John Williamson, ed., Latin American adjustment: How much has happened? Washington, DC: Institute for International Economics, 1990, pp. 5-20.