Monetary Policy, Inflation and Independence of Central Banks

The revenue raised by printing money is called seigniorage. Whenever government relies on seigniorage for financing its expenditure, the money supply goes up. Consequently, a rise in inflation is also witnessed. Raising revenue by printing more money is just like imposing an inflation tax. It is a tax in the sense that, for the holders of money, inflation decreases the real value of money.

The control over money supply is called the monetary policy. This policy works largely through its influence on the aggregate demand in an economy. It is interesting to note that in the long run, monetary policy influences the nominal or money value of goods and services which in common man’s language is known as the general price level. Movements in the general price level show how the purchasing power of money changes over time. Inflation, therefore, in essence, is a monetary phenomenon. It has to be clearly kept in mind that though monetary policy is the prime determinant of the general price level in the long run, there are many other influences on movements of price levels in short-term horizons also.

The power of any central bank to determine the interest rate in wholesale money market is derived from the fact that it is the monopoly supplier of high-powered money; also called the base money. The base money consists of notes, coins and deposits at the central bank. The operating procedure of different central banks across the globe is quite similar though there are some minor differences regarding institutional details. A central bank chooses the price at which to lend the high-powered money to the private sector institutions. The money supply is controlled by the central bank through open market operations, i.e. purchasing and selling government bonds. When the central bank wants to increase the money supply in the economy, it buys bonds from the public. As money leaves the central bank and enters into the hands of public, the amount of money in circulation increases. Contrary to this, when the central bank wants to decrease the money supply, it sells bonds to the public. This sale of bonds takes money out of the hands of public and consequently, the money in circulation decreases considerably. The quantity theory of money implies that the general price level in any economy is directly proportional to the money supply. This theory clearly elaborates that a central bank, which controls the money supply, has ultimate control over the rate of inflation. To keep the inflation under control, the central bank has to maintain the money supply. If money supply is increased rapidly, the price level will also rise with the same proportion.

All the governments know very well that the increase in money supply causes inflation. Here the question arises that what actually induces the government to increase money supply? Governments spend money to buy goods and services and to arrange for transfer payments. This spending is financed either through taxes, such as personal and corporate income taxes, or through borrowing from the public by selling bonds or by printing money. The revenue raised by printing money is called seigniorage. Whenever government relies on seigniorage for financing its expenditure, the money supply goes up. Consequently, a rise in inflation is also witnessed. Raising revenue by printing more money is just like imposing an inflation tax. It is a tax in the sense that, for the holders of money, inflation decreases the real value of money.

There is a general consensus among economists today that central banks must be given a clear mandate with price stability as their prime objective. This does not mean that they should not focus on other objectives such as high employment and strong output growth. This simply reflects the importance of containing the inflation and the fact that monetary policy can affect long-term inflation. For credibility of monetary policy, the central bank must follow a systematic and predictable pattern of behaviour. This can only be achieved if maintaining price stability is the primary goal of the central bank and its independence from government interference is also ensured. Unfortunately, the condition of State Bank in Pakistan is opposite to this.

In the words of Mr Shahid Kardar,

‘The State Bank has been battered, bruised and bludgeoned into submission by Islamabad, rendering it inchoate and impotent and with no choice but to sulk in a corner and place blame for the failure of its monetary management on supply management issues pertaining to food items and government fiscal profligacy.’

Does independence of a central bank matter in practice? Traditional empirical findings show that there is a negative correlation between central bank’s independence and inflation (the more independence a central bank has the lower will be the inflation rate) and there is no correlation between central bank independence and short-term growth (an independent central bank does not harm growth). Independence in this context means the freedom of central banks to pursue monetary policies which are not dictated by short-term political considerations. It does not, however, mean that the elected representatives cannot have a say in monetary policy or the central bank cannot consult with the government on monetary or other policies. Any action that limits the ability of governments to finance their spending from central banks is likely to enhance effective independence of the central bank.  The independence of central bank is a major policy issue today, largely because of the ongoing search for an institutional framework that will help monetary policy to deliver low inflation over the medium term. If central banks are to be independent of the government, then they must be accountable for their actions as well. Public accountability can help preserve the independence of central banks. Provided the decisions of central banks are competent, transparent and understood by the public, there will be less opportunity for political interference.

The overarching goal any monetary policy is to promote price stability. Clear institutional framework has to be installed to support this goal, to improve the effectiveness of monetary policy and to reduce the costs of bringing back inflation to the targets when it has drifted away.

By: Athar Mansoor

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