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Number 91-43, December 13, 1991

The Independence of Central Banks
What explains the difference in inflation rates
among countries? According to widely cited
studies by Bade and Parkin (1987) and Alesina
(1988), countries with central banks that have
greater legal independence in setting monetary
policy tend to have relatively lower average
inflation rates. For example, Switzerland and
Germany are said to have the most legally independent central banks and also the lowest annual
inflation rates among industrialized countries,
each averaging about 3.5 percent between 1974
and 1990. Japan and the u.s. rank next in terms
of central bank independence, with average inflation rates for the period of 5.1 and 6.3 percent,
respectively~ l\t the opposite end of the spec~rum

are the central banks of Italy and the U.K., with
relatively little formal independence. Average
annual inflation rates in Italy and the U.K. were
12.1 and 9.8 percent, respectively, during the
same period.
These findings are consistent with the theory that
inflation and the credibility of monetary policy
are linked. According to this theory, governments
are sometimes tempted to attain short-term political objectives by compromising long-term
economic goals. For example, a government may
try to win an election by printing money to increase output and reduce unemployment in the
short-run. Repeated use of this approach, however, erodes the credibility of monetary policy
and drives up the public's inflationary expectations, and hence prices, without any long-run
effect on unemployment. Placing monetary
policy under an independent authority that the
public perceives as less prone to pursue such
myopic policies provides an institutional mechanism to mitigate this credibility problem.
These findings have not gone unnoticed by
policymakers. A growing number of countries
plagued by high inflation rates in the past have
sought to give their central banks more formal
independence from the government in conducting monetary policy. Chile and New Zealand
enacted new legislation to this effect in 1989 (see

Weekly Letter November 23, 1990), and similar
proposals currently are being considered in
Argentina and in a number of Eastern European
countries, including Czechoslovakia and Poland.
As the European Community (EC) moves closer
to forming a monetary union, some member
countries have been calling for greater national
central bank independence within the Community, as a step to ultimately establishing an independent supranational central banking system.

This Letter discusses the three principal legal
determinants of central bank independenceformal central bank objectives, appointment procedure for its policy board, and financial relations
with the Treasury-by drawing on the experience
of three countries: Germany, the U.K., and Japan.
Germany and the U.K. represent the opposite
ends of the spectrum of independence. Japan
provides an interesting example where formal
legal arrangements understate the actual degree
of central bank independence. This suggests that
the establishment of a legally independent central bank is not a necessary condition for credibility of monetary policy; a well-established
reputation for controlling inflation can be an
effective substitute.
Formal objectives of central banks
In Germany, the Bundesbank Act of1957 explicitly states that the Bank "shall be independent of
instructions from the federal government." The
Bundesbank is legally obliged to support the
general economic policy of the German government "only insofar as this support does not undermine its assigned task of preserving monetary
stabiliti' This latter provision is fundamental to
safeguarding the Bank's independent position.
At the other end of the spectrum, the Bank of
England is subordinated by law to the Treasury.
The Bank of England Act (1946) stipulates that
the Treasury may issue directives to the Bank
after consultation with the Governor. This legal
provision ensures that, in the event of a disagreement, the government's position on monetary

policy will prevail over that of the Bank of England (BOE). In practice, the Treasury has never
actually issued directives, because monetary
policy is formulated through close coordination
between the Bank and the Treasury, with the
latter having the upper hand.
japan falls somewhere between these two examples. Legally, the Bank of japan (BOj) can independently determine discount rate policy and
open market operations. In other respects, however, the BOj's independence is significantly
curtailed. For instance, any change in commercial banks' reserve ratios requires approval of the
Ministry of Finance (MOF). In fact, the Bank of
japan Law (1942) empowers the Finance Minister
to direct the BOJ to change its bylaws or to undertake any actions it deems necessary. This
power, however, has never been exercised, and
in practice, major monetary policy issues are
determined through close cooperation between
the BOj and the MOF, which is facilitated by
having a (non-voting) MOF representative on the
Bank's Policy Board.
Appointment of central bank policy boards

Governments may exercise leverage over central
banks by controlling the appointment and dismissal of members of the monetary policy board.
The degree of a central bank's independence
can thus be enhanced by limiting these powers,
for example, by making the terms of board
members longer than the electoral cycle, or by
limiting the proportion of policy board members
that can be directly nominated or appointed by
the government.
When the government is responsible for formulating monetary policy, it typically controls
directly all appointments to the policy board of
the central bank. In the U.K., the Governor, Deputy Governor, and directors of the BOE are all
appointed by the Crown, which in practice
means by the Prime Minister acting on the advice of the Chancellor of Exchequer (Treasury).
The Governor and Deputy Governor are appointed for renewable terms of five years; the directors
have staggered four-year terms which are also
Although the Bank of japan is considered to be a
relatively independent central bank, all positions
on its Policy Board are direct government ap-

pointments. The Board consists of seven members: the Governor, appointed by the Prime
Minister's Cabinet for a five-year renewable term,
two nonvoting members serving ex officio as representatives of the tViinistry of Finance and of the
Economic Planning Agency, and four voting members appointed for four years by the Cabinet with
the consent of both Houses.
In Germany, the Central Bank Council determines the monetary and credit policies of the
Bundesbank. It consists of the ten-member
Directorate and the eleven Land (district) Central
Bank Presidents. The Directorate, which includes
the President and the Vice President, are nominated by the federal government and appointed
by the President of the Federal Republic for a
period of eight years. The President of the Federal
Republic also appoints the eleven Land Bank
Presidents for eight-year (renewable) terms. Their
nomination, however, must come from the Bundesrat, the upper house of the parliament, which
represents the various regions of the country. In
making a nomination, the Bundesrat must follow
the recommendation of the political authority in
the Land concerned. This ensures that the federal
government is not able to nominate directly a
majority of the Central Bank Council. As a further
check on the government's direct input in the
appointment process, the Central Bank Council
has the right to comment on the nomination of any
Directorate member or Land Bank President.
Financial relations between
central banks and governments

Budgetary autonomy would seem to be a natural
feature of central bank independence. But, in
fact, many central banks along the entire spectrum of independence have complete budget
autonomy. The Bank of japan, along with the
Bank of France and the Reserve Bank of New
Zealand, are notable exceptions; all must obtain
prior approval from the government for their
budget expenditures. One possible reason why
budgetary autonomy is not linked to monetary
policy independence is that, unlike other government agencies, virtually all central banks
generate revenue from seignorage or assets purchased by creating non-interest bearing (or low
interest-bearing) liabilities against themselves.
A significant determinant of central bank independence is the extent to which the government

can obtain financing directly from the central
bank. The more power the Treasury has to demand direct financing from the central bank, the
less latitude the central bank has in pursuing
monetary policies aimed at maintaining longterm price stability. In Germany, direct central
bank credit to the government is strictly limited,
but the Bundesbank is allowed to acquire government paper in open market operations. The
law explicitly states, however, that such secondary market purchases can be used only for monetary control purposes. In the U.K., the Treasury
can cover current budget spending requirements
with direct short-term loans from the BOE. Moreover, the law does not limit BOE purchases of
government securities. In japan, the BOj is prohibited from direct purchases of new issues of
long-term government securities, but there is no
barrier to BOj advances to the government or
secondary market purchases of government debt.

law versus reputation
Formal legal arrangements of central banking in
Germany and the U.K. give a fairly clear indication of the degree of their independence. And,
the relative inflationary performance both countries is consistent with the notion that independent central banks tend to generate lower inflation rates. In japan, less formal arrangements and
practices (which are more difficult to measure)
also have been important; monetary policy generally has been more independent in practice
than central bank legislation suggests. In other
words, achieving low inflation has been possible
in Japan without the benefit of a particularly
legally independent central bank.
This achievement may be explained by the BOl's
trustworthy record of keeping inflation in check.
Such a reputation may have provided an effective

substitute for legal independence in establishing
policy credibility. Of course, the two are not mutually exclusive, as the German case illustrates,
where the Bundesbank's track record in controlling inflation has been even more impressive. No
doubt, the collective memory of hyperinflation
contributed to Germany's decision to buttress
high central bank reputation with legal safeguards for its independence.
Establishing formal independence will be particularly important for a country attempting to build
monetary policy credibility against an historical
background of variable and insufficient monetary
restraint. Perhaps it is not a coincidence that
countries with particularly poor inflation records
in the past, such as Argentina, Chile, New Zealand, and some of the Eastern European countries,
are the very ones that have recently formalized,
or are contemplating formalizing, the independence of their central banks. Formal central bank
independence may offer the potential to provide
a disciplinary check on monetary policy and
thereby improve long-run inflation performance.

Sun Rae Kim

Alesina, Alberto. 1988. "Macroeconomics and Politics." In NBER Macroeonomic Annual, 1988,
Cambridge Mass., MIT Press.
Bade, Robin and Michael Parkin. 1987. "Central Bank
Laws and Monetary Policy." Unpublished mimeograph. Department of Economics, University of
Western Ontario.

Opinions expressed in this newsletter do not necessarily refied the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author..•• Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
Printed on recycled paper ~ .,),
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Index to Recent Issues of FRBSF Weekly Letter



(91-21 )





Financial Constraints and Bank Credit
Ending Inflation
Using Consumption to Forecast Income
Free Trade with Mexico?
Is the Prime Rate Too High?
Consumer Confidence and the Outlook for Consumer Spending Throop
Real Estate Loan Problems in the West
Aerospace Downturn
Public Preferences and Inflation
Bank Branching and Portfolio Diversification
Laderman/Sch midt!
The Gulf War and the
The Negative Effects of Lender Liability
M2 and the Business Cycle
International Output Comparisons
Is Banking Really Prone to Panics?
Deposit Insurance: Recapitalize or Reform?
Earnings Plummet at Western Banks
Bank Stock Risk and Return
The False Hope of the Narrow Bank
The Regional Concentration of Recessions
Real Wages in the 1980s
Solving the Mystery of High Credit Card Rates


The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.