Michael Tsiagbe 0927139 BSc Econ
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Discuss the effect of greater Central Bank independence on inflation, both intheory and with respect to empirical evidence
The following paper will explore the concept of Central Bank independence and thearguments for and against it supported by theory and empirical evidence alike. This paper willbe structured as follows: Section ia will introduce the concept of inflation, section ib will lookat the Central Bank and its purpose within an economy, section ic will look into the concept of Central Bank independence, sections iia and iib will look at the theoretical and empiricalaspects of Central Bank independence respectively, iic will look at scenarios where greaterCentral Bank independence may not always work and finally section iii will conclude thepaper.
ia. What is inflation, and what causes it?
By the end of 2001 the average house price in the UK was £92,533
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, by the end of fourthquarter of 2010 on average house prices were £162,379
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. This increase in overall price levelsis known inflation best defined as the continuous increase in the overall price level within aneconomy inflation can be a problem for many economies small and large alike. The modernmeasure of inflation, known as the Consumer Price Index (CPI) is a weighted measure of a basket of goods from which the average price level is derived on a month to month basis(within the UK). Inflation has long been a conundrum for governments and Central Banksalike, especially in their pursuits of trying to eliminate the economic undesirable of highunemployment.
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Figures provided by http://www.housepricecrash.co.uk/indices-nationwide-national-inflation.php
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Mankiw, Principles of Macroeconomics, page 75
Michael Tsiagbe 0927139 BSc EconSo what is the cause of inflation? Nobel Prize winning economist Milton Freidmann told us inflation is always and everywhere a monetary phenomenon. In order to understandinflation we have to begin to look at the classical theory of inflation, the distinct primaryassumptions of this theory being that we consider price levels to be flexible and markets areclear. As stated by Mankiw (2004)
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most economists believe this assumption describes thebehaviour of the economy in the long run
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. There are various reasons of from which inflationcan arise. One such explanation for the causes of inflation can be derived from what is knownas the Quantity Theory of Money, this theory is an identity given by the equation:
Where
M
denotes the money supply,
V
the velocity of circulation of money,
P
the aggregateprice level and
Y
output. The quantity equation gives us a simple relationship between theaggregate level of prices and the stock of money in the economy. What the quantity equationtells us in the context of inflation is that the price level is proportionate to the amount of money within an economy. This is qualified when we assume the Velocity of Circulation (V) tobe constant, as a result changes in the money supply must cause a proportionate change innominal GDP. However, if Real GDP is determined by the economys supplies of capital andlabour and their combination in the production process then the equation implies that changes in money will translate into changes in the price level. Furthermore we can rewriteour quantity equation to consider the effects of economic growth within an economy, stillassuming the velocity of circulation as constant we can state:
Given this we can state that, in terms of growth the inflation rate is given by:
That being the equivalent of:
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Mankiw, Principles of Macroeconomics, page 75
Michael Tsiagbe 0927139 BSc EconThat is economic growth requires a certain increase in the money supply to facilitate thehigher amounts of transactions that occur, money growth in excess of this leads to inflation.Furthermore empirical evidence suggests that the long term money growth rate of countriesis generally similar to their trends of inflation. These theories build the foundations of monetarism upon which modern monetary policy is based upon.
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