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The Revolution in Monetary Policymaking Institutions

The nature of central banking and monetary policy formulation has changed radically over the past two decades. The revolution was driven by the interaction of monetary policy failures and theoretical developments.

Twenty years ago and earlier, most central banks in the world functioned as departments of ministries of finance. They were expected - by law, custom, or both - to utilise their policy instruments to achieve a myriad of objectives, including high levels of growth and employment, provision of funds to government for the financing of public expenditures and addressing balance-of-payments problems.1 They also were expected to maintain financial and price stability, but the price stability objective was one among several other objectives in the charter of the Bank and had no particular status. In some cases, like Spain and Norway, it did not even appear in the charter.2 Paralleling this state of affairs, economic theory did not attribute particular importance to central-bank independence and the concept of credibility of monetary policy was in early stages of development. Furthermore, a notable legacy of the Keynesian revolution was the belief that a certain amount of inflation is conducive to economic growth.

Although some banks had a reasonable amount of legal independence, the level of actual independence, particularly in developing countries, was usually lower than the one indicated in the law. Except for a few cases, central banks did not possess instrument independence and the responsibility for price stability was, at least implicitly, located in the ministry of finance and other economic branches of government. In a few developed economies (like the UK, Japan, the US and West Germany) with wide capital markets, price stability was maintained mainly through the actions of relatively conservative treasury departments or because of de-facto independent central banks.3

Most other countries that enjoyed reasonable levels of price stability achieved this result by pegging their currencies to the currency of a country with sufficiently conservative aggregate nominal policies. Under the Bretton Woods system, most currencies were automatically pegged to the US dollar. Following the breakdown of this system in the seventies, many countries adopted unilateral pegs and later on, bands. Countries without any of those three commitment devices endured prolonged episodes of high and variable inflation as exemplified by the cases of Argentina, Brazil, Israel, Mexico, Chile and other countries.

The present

The contrast of this state of affairs with current practice and consensus regarding central-bank independence cannot be overemphasised. Most central banks in today's world enjoy substantially higher levels of both legal and actual independence than twenty years ago or earlier. Central bank independence and accompanying institutional arrangements like inflation targeting have become widely accepted commitment devices. In spite of some contentious issues, the following broad practical consensus backed by academic work has emerged. The primary responsibility of the central bank is to assure price stability and financial stability. In particular, the price stability objective is elevated to special status and, in a growing number of countries, is communicated to the public by pre-announcing an inflation target. Without prejudice to the price stability objective, the central bank is expected to support the economic policies of government. To achieve its main objective the bank is given instrument independence.4

Delegation of authority to a non-elected institution is expected to be accompanied by accountability and transparency. It is noteworthy that those two buzz words of modern monetary institutions were hardly heard twenty years ago or earlier. In the absence of central-bank independence, politicians did not insist on accountability and transparency. As political entities, governments and ministries of finance had little incentive to raise questions about their own transparency in the conduct of monetary policy.

Why did central bank independence increase so much during the last two decades?

Most of the revolution in monetary policymaking institutions took place during the last decade of the twentieth century and the beginning of the current century.5 It was triggered by a combination of both global and regional factors.

Three main global factors underlie the trend towards higher central-bank independence. One is an increased worldwide quest for price stability, induced by the stagflation of the seventies and the dismal economic performance of some high inflation countries, in Latin America and elsewhere. Contrary to the sixties and the seventies, the accepted view during the eighties and nineties became that inflation and the associated uncertainties retard growth. The relatively good real performance of some low inflation countries like Germany and Japan supported this view until the eighties .

The second factor is the gradual dismantling of controls on capital flows and the associated widening of international capital markets. Those processes reinforced the quest for price stability and raised the importance of central-bank independence as a signal of macroeconomic nominal responsibility to domestic and international investors. As argued by Maxfield (1998), this factor was particularly important in developing countries whose political establishments were anxious to establish smooth access to international capital markets.6 Additionally, the IMF embraced the view that a high level of independence is a desirable institutional feature and actively promoted central bank reform in many developing economies through conditionality and other means.

The third worldwide factor is the intellectual revolution triggered by the view that governments are subject to an inflation bias that stems from attempts to maintain overly ambitious levels of employment and/or to finance budget deficits by means of money creation. This view helped cement a consensus that efforts to use money to raise output beyond its potential level is ineffective and only leads to socially harmful inflation.7 By offering a relatively simple theory of the prisoner's dilemma aspects of the interaction between monetary policymakers and individuals in the economy, the inflation bias model provided academic credence for the claim that monetary policy should be delegated to a sufficiently independent central bank and helped spread this notion internationally.8

What are the broad regional motives for increasing independence? First is the breakdown of other institutions designed to safeguard nominal stability like the Bretton Wood System and the European Monetary System. The demise of those arrangements intensified the search for alternative institutions. Second, the good track record of the highly independent Bundesbank demonstrated that central-bank independence can function as an effective device for assuring nominal stability. Third, the acceptance of the Maastricht Treaty by the European Economic Community implied that many countries in the Community had to upgrade the independence of their CB as a precondition for membership in European Monetary Union. The fact that such a stipulation has been introduced in the Treaty in the first place is related to the good record of the Bundesbank and to the central position of Germany within the Community.

Fourth, after successful stabilisation of inflation in Latin America during the eighties and nineties, policymakers were looking for institutional arrangements capable of reducing the likelihood that high and persistent inflation will recur in the future. In view of the experience available at the time, raising central-bank independence was a natural way to achieve this objective. Fifth, the upgrading of central-bank independence and the creation of best-practice Western type central banks in the former socialist countries was part of a more general attempt by these countries to create the institutional framework needed for the orderly functioning of a market economy. The fact that many of these new central banks were granted substantial de-jure independence was no doubt motivated by evidence from the industrial economies, suggesting that inflation and legal independence are negatively related and that independence and growth are either positively related or unrelated.9


1 In the case of many developing countries, the central bank often functionned as a development bank that provided subsidised loans to various sectors of the economy.

2 Further details appear in Cukierman A. (1992), Central Bank Strategy, Credibility and Independence: Theory and Evidence, The MIT Press, Cambridge, MA.. (particularly chapter 19).

3 Partly because of the US-wide capital markets, the de-facto independence of the Federal Reserve was higher than its legal independence. At the time, West Germany's Bundesbank was unique in that it enjoyed both de-jure as well as de-facto independence.

4 In a few cases like the European Central Bank and the Banco Central de Chile, the bank is even given some limited goal independence in the sense that it is free to determine its own inflation target.

5 More details appear in subsection 2.1 of Cukierman A. (2007), “Central Bank Independence and Monetary Policymaking Institutions - Past Present and Future”, CEPR Discussion Paper 6441, September.

6 Maxfield S. (1998) Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries, Princeton University Press, Princeton, NJ.

7 The foundations for this view were first laid out in Kydland F. E. and Prescott E. C. (1977), "Rules Rather Than Discretion : The Inconsistency of Optimal Plans", Journal of Political Economy, 85, 473-92 and elaborated in Barro R. J. and Gordon R. (1983), "A Positive Theory of Monetary Policy in a Natural Rate Model", Journal of Political Economy, 91, 589-610. The ways in which various real objectives of governments combine with the public’s inflationary expectations to produce an inflation bias are dealt in part I of Cukierman (1992) Op. Cit..

8 The conceptual case for reducing the bias by delegating authority to an independent CB that attaches more importance to price stability than government appears in Rogoff K. (1985), "The Optimal Degree of Commitment to a Monetary Target", Quarterly Journal of Economics, 100, 1169-1190.

9 Further evidence on central-bank independence and the performance of the economy is summarised in section 2.3 of Cukierman (2007), Op. Cit..

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