3
$\begingroup$

To begin with, CB (central bank) independence is defined as not being subject to government influence.

If CB only cares about inflation, it is easy to be independent.

If CB also needs to guarantee employment, isn't much of the independence already out of the door? Whenever the government mismanages the economy in some way, there will be unemployment, and CB will have to print money by mandate.

Taken to an extreme: suppose the government decides to take on massive debt for some purposes (war, social programs, etc). If that triggers social problems and unemployment, doesn't that automatically forces the CB to print money by mandate?

$\endgroup$

1 Answer 1

3
$\begingroup$

If CB also needs to guarantee employment, isn't much of the independence already out of the door? Whenever the government mismanages the economy in some way, there will be unemployment, and CB will have to print money by mandate.

You could make the same argument even with pure inflation mandate. It is well known that drop in real potential output is inflationary. Ergo, if government screws economy too badly there will be inflation, which will force central bank to respond by tightening monetary policy.

However, central bank independence does not mean that central bank does not respond to government actions. Central bank independence is defined as monetary policy being independent from short-term political pressure (Jordan & Luther 2020). Nonetheless, even without any pressure central bank inevitably has to respond to government action no matter how it’s mandate is set up as long as the mandate targets some macroeconomic indicator. This is purely because almost anything government does has some effect on the economy.

Taken to an extreme: suppose the government decides to take on massive debt for some purposes (war, social programs, etc). If that triggers social problems and unemployment, doesn't that automatically forces the CB to print money by mandate?

Not necessarily. First, there are different other ways how to conduct loose monetary policy. Some CBs can’t even directly print money (such as Fed) so they focus more on interest rates or OMOs which create new money but not by printing.

Second, central bank still has some flexibility in deciding which of its goal will be given higher weight. There is also some flexibility in the definitions of price stability and full employment.

For example Fed interprets it’s price stability mandate as average inflation being 2% and unemployment being above natural rate of unemployment (see Fed). These definitions are ultimately more or less arbitrary. For example, why is the inflation target 2% instead of 2.1% or 1.5? There is no good reason for choosing 2% as opposed to 2.1 or 1.5, it’s purely at Fed’s discretion.

As mentioned above this does not violate central bank independence in itself. A violation of central bank independence would be if Fed faces political pressure, for example pressure from sitting president to avoid rising interest rates even when Fed believes that’s best to pursue its mandate.

$\endgroup$
8
  • $\begingroup$ Thanks much for the answer. I certainly agree that even if CB only cares about inflation, it will also have to respond to government actions, but this is going to be an offsetting force, but the unemployment mandate --- in my view --- may lead to CB exacerbating the issue. If the government rolls out a massive fiscal stimulus that leads to inflation, CB will respond by hiking interest rates and cooling the economy. But if the government over-borrows today and pushes its future self towards bankruptcy, an employment-targeting CB will have no choice but to monetize the debt when that happens. $\endgroup$
    – J Li
    Sep 5, 2022 at 14:52
  • $\begingroup$ @JLi yes but that does not make it not independent… CB is not supposed to be either enemy or friend of the government. They are not supposed to offset government policy just for the sake of offsetting it. In fact they are government institutions. CB independence is the same sort of independence that courts have. An independent court is one where court decision is made following law without direct political influence. However, when politicians pass bad laws independent courts will still enforce them even if they are in government’s favor such as expropriation laws etc. $\endgroup$
    – 1muflon1
    Sep 5, 2022 at 15:05
  • $\begingroup$ It seems that we have a different notion of independence here. It seems you are talking about "procedural independence" while I am talking about "substantive independence". $\endgroup$
    – J Li
    Sep 5, 2022 at 15:17
  • $\begingroup$ @JLi what is substantive independence? $\endgroup$ Sep 5, 2022 at 15:50
  • $\begingroup$ @JLi how do you define “substantive independence” visa-a-vis “procedural independence”? Those are not terms used in literature on CB independence. $\endgroup$
    – 1muflon1
    Sep 5, 2022 at 18:36

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.