How does central bank independence affect the conduct and outcome of monetary policy? : A case study : Bank of England versus Bundesbank

Abstract

The question whether monetary policy should be subject to discretion or whether some kind of rule should be imposed upon its conduct has been and is subject to intensive debate. The theoretical rationale for central bank independence is to be found in the 'time-inconsistency' literature, which demonstrates that if monetary policy is entrusted in discretionary fashion to policy makers, they have an incentive to renege on their precommitment since they favour short-run output gains. The public forms expectations about the credibility of a pre-announced strategy of the policy maker. It is argued that an independent monetary authority, which is committed to price stability, would be an accountable player in the monetary policy game, removing the need for the wage bargainers to protect themselves against inflationary surprises. Many studies have been dedicated to approach the 'case for central bank independence' from the empirical side. Various indices of central bank independence have been developed, based on a uniform assessment procedure which allows a comparison of alternative monetary arrangements according to their degree of independence. An inverse relationship between the rate of inflation and central bank independence is generally advocated. The empirical findings, however, suggest a less clear-cut relationship than that claimed by the theoretical literature. To allow a well-founded statement about how central bank independence affects the conduct and outcome of monetary policy, one needs to look at different monetary regimes. The Bank of England, politically dependent on the government, and the independent German Bundesbank have been chosen as test cases. The inflationary performance of Germany has been on average better and more stable when compared to the United Kingdom's record. The respective monetary arrangement determined and had at times decisive influence on policy decisions. The discretionary regime in the United Kingdom allowed the authorities recourse to expansionary monetary policies, whereas this was impossible for the German government, since the Bundesbank conducts its policy independent from government directives and adheres to its pre-eminent task of safeguarding the currency. It is concluded that an independent central bank which is committed to price stability generates a better inflationary outcome than that achieved with a discretionary conduct of monetary policy. Furthermore, autonomy and the commitment to protecting the internal value of the currency are important devices for building an anti-inflationary reputation.