The relationship between the degree of central bank independence and the rate

of inflation has been intensely investigated over a number of years. Investigators

have constructed many indices of central bank independence. The primary

difficulty in trying to objectively analyse the merits of central bank independence

is that all indices of independence to some degree are subjective. This problem

is further exacerbated by the fact that findings are very sensitive to even slight

variations in the ranking of criteria. Grilli, Masciandaro and Tabellini (GMT 1991)

constructed a double index based on political and economic criteria. The political

independence criteria attempts to measure the ability of the central bank to

devise its own objectives (i.e. goal independence) without influence from the

government.
 
 

The political criteria are as follows:

(1) The governor is not appointed by the government.

 (2) The governor is appointed for more than a five – year term.

 (3) All the board of directors are not appointed by the government.

 (4) The board is appointed for more than a five – year term.

 (5) There is no mandatory participation of a government representative or

representative on the board.

 (6) There is no requirement for the government to approve monetary policy f

formulation.

 (7) Statute stipulates that the central bank must pursue monetary stability, at

least as one of its goals.

 (8) There are legal provisions that support the central banks position in the event

of conflict with the government.
 

Table 1, constructed by Dowd and Baker (1996) shows how successful the

Reserve Bank was at meeting these criteria, before and after the 1989 Act.

                                                    Table 1
                      Political Independence of the Reserve Bank

                                             1     2     3     4     5     6     7     8     Total

                        1964 Act       0     0     0     0     0     0     0     0        0
                        1989 Act     0.5*  0     1     0     1     1     1     1       5.5

                       Source: Dowd and Baker 1996
 

* 0.5 reflects the fact that the Minister of Finance appoints the governor, but from a short-list of candidates selected by the banks board of directors.
 
 

The economic independence criteria attempt to measure the ability of the central

bank to use policy instruments without approval from the government (instrument

independence). An important criterion for this is whether or not the central bank

is compelled to finance government deficit. An increasing index indicates greater

central bank independence.

The economic criteria are as follows:

 (1) The government does not have an automatic credit facility with the bank.

 (2) When the government borrows from the bank it is at the market interest rate.

 (3) The government can only borrow temporally from the central bank.

 (4) Any borrowing from the central bank is subject to an upper limit.

 (5) The central bank does not participate in the primary market for government

debt.

 (6) The discount rate is set by the central bank.

 (7) Banking supervision is exclusive to the central bank.

                                                          Table 2
                    Economic Independence of the Reserve Bank

                                          1     2     3     4     5     6     7     Total

                     1964 Act       0     0     1     1     1     0     0        3
                     1989 Act       1     1     1     1     1     1     1        7

                        Source: Dowd and Baker 1996

                    Total of 12.5 after the 1989 Act compared to a total of 3 previously.
 
 

Although there are variations in the rankings of the different indices, the results

are broadly consistent with each other, showing a negative relationship between

the degree of central bank independence and average rates of inflation.
 

Chart 1.3 shows the relationship between the average rates of inflation and the

degree of central bank independence. As we can see, there is a clear negative

relationship between the inflation and the degree of central bank independence

for Hungary, Slovakia and Czech Republic but it does not hold for the rest of the

countries.