The Revolution in Monetary Policymaking Institutions

1. The past versus the present

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 utilize their policy instruments to achieve a myriad of objectives like high levels of growth and employment, provision of funds to government for the financing of public expenditures and to address 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 charter2 of the Bank and had no particular status. In some cases like Spain and Norway it did not even appear in the charter. Paralleling this state of affairs economic theory did not attribute particular importance to central bank independence (CBI) 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.

The contrast of this state of affairs with current practice and consensus regarding CBI cannot be overemphasized. Most central banks in today’s world enjoy substantially higher levels of both legal and actual independence than twenty years ago or earlier. CBI 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 (CB) 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 preannouncing an inflation target. Without prejudice to the price stability objective the CB is expected to support the economic policies of government. To achieve its main objective the bank is given instrument independence.3

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 CBI, 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.

2. 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.4 It was trigerred by a combination of both global and regional factors.

Three main global factors underlie the trend towards higher CBI. One is an increased world wide 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 the nineties, became that inflation and the associated uncertainties retard growth. The relatively good real performance of some low inflation countries like Germany and Japan till the eighties supported this view.

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 CBI as a signal of 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.5 Relatedly, the IMF embraced the view that a high level of independence is a desirable institutional feature and actively promoted CB 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 due to 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 trying to use money to raise output beyond its potential level is ineffective and only leads to socially harmful inflation.6 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 CB and helped spread this notion internationally.7

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 CBI can function as an effective device for assuring nominal stability. Third, the acceptance of the Maastricht Treaty by the European Economic Community implied that in order to conform with the Treaty 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 stabilization of inflation in Latin America during the eighties and the 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 CBI was a natural way to achieve this objective. Fifth, the upgrading of CBI 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.8


(1) In the case of many developing countries the central bank often functionned as a development bank that provided subsidized 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) 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.

(4) 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 or click here to access the paper. (5) Maxfield S. (1998) Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries, Princeton University Press, Princeton, NJ.

(6) 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..

(7) 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.

(8) Further evidence on CBI and the performance of the economy is summarized in section 2.3 of Cukierman (2007), Op. Cit..

6 Responses to "The Revolution in Monetary Policymaking Institutions"

  1. Vitoria Saddi   May 13, 2008 at 8:55 am

    Alex,What do you think about the independence of the Central Bank of Chile and the fact that they were ‘forced’ to intervene in the FX market and thus promoting a depreciation in the domestic currency that may lead to higher inflation?In contrast, the Central Bank of Brazil is not independent but has build credibility to the point that nobody interfere in their policies. What is your view?ThanksVitoria

  2. Guest   May 13, 2008 at 9:04 am

    As the famous Mayer Rothschild once said more or less " GIVE ME THE POWER TO PRINT THE MONEY OF A GOVERNMENT AND I WILL HAVE CONTROL OF THAT GOVERNMENT."As long as a Central Bank is a private institution run for profit there is danger on the horizon. The world could be a better place if this was not the case.

  3. Anonymous   May 15, 2008 at 6:24 pm

    Will inflation targeting survive the current rise in global inflation? Finally we will have a true test of central bank independence and of the effectiveness of inflation targeting.

  4. eugeen nxumalo   May 16, 2008 at 2:48 am

    what about the central bank position in zimbabwean politics compare that to south frica.

  5. OuterBeltway   June 17, 2008 at 7:15 am

    If the CBs are only responsible for managing inflation, why did the U.S. Fed allow M3 to skyrocket from 2002 through 2007? If the CBs are so independent, how do you explain the bailouts (not just BearStearns, but Citibank, LTCM, etc.)? The "independence" is a myth, at least in the U.S.At this point in time, the U.S. lacks a powerful, independent, fact-checkable authority that makes pronouncements on the economic utility to the nation of the various policies set both by private industry (e.g. Enron, oil commodity markets) and by government (e.g. energy policy, wars-of-choice). People look to the Fed for honest-broker economic guidance, but that’s not what the Fed is. The Fed seems to be behaving as a trade association for bankers.This is not conspiracy theory. Look at the behavior, and ask yourself if the Fed’s actions over the past decade have truly been in the interests of the average American citizen. What do you think?

  6. OuterBeltway   June 17, 2008 at 8:58 am

    Furthermore, it seems a misnomer to me to call the devolution of the U.S. central bank’s role "revolutionary". If the role has shifted from "national economic policy implementor" to "price stabilizer", you’d have to say that the U.S. Fed has performed neither function well. I don’t call that "revolutionary". I call it "dysfunctional".The Fed has not called it like it is. It has explained to the American people why it was necessary to expand M3 into the stratosphere. It has not explained why it permitted the rating agencies to paint lipstick on pigs, and then fob that rubbish off on our trusting trading partners. The U.S. Fed has presided over the hollowing out (destruction) of the U.S. economy over the past 20 years, and has done nothing but manipulate money supply growth in order to keep the consumption party going.