In simple terms, the central bank is the authority that is in charge of a country’s currency, supply of money, interest rate and credit. More specifically, the central bank uses its monetary policy tools to achieve certain objectives for the benefit of the economic interests of the nation and also to consistent with the government fiscal policy. The idea of central bank can trace back to 17th century. Ever since, a number of countries, such as France, New Zealand, Spain, and the United Kingdom, enact law to make their own central banks more isolate from the government after witnessing the good practice of Germany and Switzerland. So far, the most independent central bank in term of conduction of monetary policy are the European Central Bank and Federal Reserve System in the United State.
In this paper we would discuss about three crucial characteristics that lead to the success of an independent central bank.
There is an increasing agreement that a low and stable inflation rate referred to price stability is good for the economy. Some researches indicate that a low and stable inflation rate could help enhance the rate of economic growth.
The concept of inflation bias was initially introduced by Kydland and Prescott (1977), they predicted if monetary policy maker is guided by discretion rather than rules, there is a great chance to have time inconsistent problems which, in turn, leads to inflation bias. It is showed, in Barro-Gordon model, that a nation will attempt to lower the unemployment and stimulate output since that will make public be more in favour of government. This action is quite common especially when there is a re-election of government. Based on the Phillips curve, we can know that lower unemployment in an economic is correlated with a higher rate of inflation. Overall, government has a motivation to create unexpected inflation.
Due to the dangers of inflation bias, many suggestions has come up, the mainstream idea is taking monetary policy away from government. According to the article proposed by Rogoff in 1985, the way to reduce the inflation bias is to delegate monetary policy to a central banker who is more averse to inflation than elected government, i.e., he put more relative weight on avoiding inflation than unemployment in the social loss function. He described such person as a conservative central banker. The expected and actual rate of inflation would go down as the preferences of this person are known. It is emphasis in his model that the independency of the central bank plays a major role in eliminating inflation bias. When a central bank has enough independence with rest of the things remain the same, its conservatism has a negative correlation with equilibrium inflation. This mechanism can be seen as a remedy for time-inconsistent problem---one of the key issues facing by central bank.
Thought the main idea of conservative central bank is generally adopted. Inevitably, there are some criticisms...