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Monetary Economics in Developing Countries

(FE3178), 2009-2010

Monetary policy institutions

GSF, Chapter 7

Central bank independence

Understanding how monetary policy institutions operate

is critical.

Why? The policymaking process involves interactions

between different sectors of the government and

economic agents in the wider economy.

In that context issues like the independence of central

banks play a prominent role.

Important theoretical contributions like Kydland and

Prescott’s 1977 seminal work generating the rules-

versus-discretion debate.

See also Barro and Gordon (1983).


That literature conjectures that policymakers (e.g. central

bankers) will have a temptation to follow inflationary

policies in pursuing a higher level of output.

But assuming rational expectations implies that such a

behaviour only leads to an inefficiently higher level of

inflation (an ‘inflation bias’) without corresponding

output gains.

That result connects to central bank independence via the

influence of political factors in determining policy


Related works: Rogoff (1985) and Walsh (1995).


These authors advance potential solutions to the

‘inflation bias’ problem.

Rogoff suggests appointing a ‘conservative central

banker’ who is averse to inflation.

Walsh puts forward the notion of designing optimal

contracts for central bankers tied to achieving a certain

inflation target.

But McCallum (1997) argues that the ‘inflationary bias’

described above should not be presumed.

In any case the problem likely involves considering other

parts of the government and not only the central bank.


Pursuing legal central bank independence is not a


Blinder (1999) is also rather critical of ideas like optimal

contracts for central bankers.

Still, there is a significant literature on central bank


Cukierman (1992) advances useful theoretical political

economy and empirical insights into crucial issues such

as the link between central banks’ independence and

inflation in a cross-section of developed and developing


A key finding arising from that research programme is

that central bank independence is negatively related to

inflation (See also Alesina and Summers, 1993).

That is, the more independent monetary authorities are in

designing and implementing monetary policy the lower

is the corresponding rate of inflation observed for a given


Important result. Why? Because (as is argued

elsewhere in this book) keeping inflation in check is an

essential pre-condition for economic growth and


But note that the relationship in question does not imply


From a political economy perspective legal independence

may raise problems of accountability because central

bankers are generally unelected officials.

Cukierman et al (1992) find that legal independence is

not as importantly related to inflation in developing as it

is in developed economies.

They do find that a measure of central bank governors’

turnover rates is related to inflation in developing


Their turnover indicator basically accounts for the

number of times central bank governors are changed

during a particular time period.


de Haan and Kooi (2000) attempt to improve on

previous efforts aimed at understanding central bank

independence in developing countries.

They advance a measure of central bank independence

by considering central bank governors’ turnover rate.

In particular, they construct an indicator of central

bank independence (CBI) using information from the

International Monetary Fund and from national central


They look into these sources and account for changes in

the central bank’s governor.

The approach follows Cukierman et al’s (1992) which

argues that standard measures based on legal


independence may be less appropriate for understanding

central bank behaviour in a developing economy context.

de Haan and Kooi employ data for 82 developing

countries over the span 1980–1989.

The exercise has an obvious limitation arising from the

fact that it only examines a decade of information –

which the authors justify because it allows them to

compare their index with Cukierman et al’s (1992)

comprising the same time period.

Additionally, the 1980s were a particularly difficult time

for developing countries facing economic turmoil,

notoriously coining terms such as the ‘lost decade’ in

Latin America.

Further, de Haan and Kooi employ cross-section

analysis, i.e. using average turnover rates and inflation

rates during 1980-1989, and that involves potential

shortcomings in the accuracy of the econometric


Table 7.1 displays their central bank turnover index for

82 developing countries, where a higher number implies

a higher turnover rate.

The empirical analysis goes some way in showing that de

Haan and Kooi’s proxy for CBI is significantly and

negatively related to inflation.

That is, a higher score in their CBI index implies

observing, on average, a higher inflation rate in the

corresponding economy.

That result is quite sensible to including high inflation

countries in the sample.

de Haan and Kooi’s CBI indicator is not significant

when their modelling excludes high inflation countries.

They do not find support for the argument sustaining that

CBI arises from opposition towards inflation.

And, critically, they do not find evidence that CBI is

robustly related to economic growth.

The latter is an important conclusion.

But further evidence is needed before we can derive solid

conclusions on this critical matter.


Case study:

Central bank independence and inflation in Colombia

Otero and Ramírez (2006) investigate Colombia’s

move in 1991 towards a more independent monetary

policy by granting greater autonomy to its central bank.

That is a policy outcome related to the wider literature on

central bank independence motivated by, inter alia,

Cukierman’s (1992) work.

Their contribution is examining if granting more

independence to the central bank actually helps in

explaining inflationary developments in Colombia over

and above a battery of indicators.


They consider potential inflationary developments

arising from the money market, the labour market, and

external sources.

Otero and Ramírez’s key finding is that inflationary

pressure from the money market and from the goods

market are lower following the 1991 Constitutional

reform conceding greater independence to Colombia’s

central bank.

That is, in Colombia’s case greater independence has

indeed led to a better outcome regarding the central

bank’s mandate of achieving price stability.


Central banking in the ‘Bank of England Group’ of

developing countries

Fry, Goodhart, and Almeida (1996) embark on an

ambitious research project sponsored by the Bank of

England aiming to improve our understanding of central

banking in developing countries.

In so doing they inquiry into monetary policy design and

implementation issues in 44 developing countries -which

they label the ‘Bank of England Group’.

As the authors concede, their choice of countries raises

obvious concerns regarding sample bias.

In tackling that matter they examine a battery of

indicators (e.g. trend output growth rate, inflation, and


several monetary and government finance indicators) for

the Bank of England Group in comparison with a control

group of 79 developing countries and with a group of 20

OECD countries for the period 1979-1993.

Based on that, rather informal, inspection, Fry, Goodhart,

and Almeida conclude that their sample countries seem

to represent developing countries’ features.

However, as expected, they differ from the OECD


As a result their investigation proceeds assuming that the

findings reached for their sample will be at least

approximately relevant for developing countries in


The authors’ research strategy relies on administering

questionnaires to 44 central banks in Africa, Asia, the

Middle East, Europe, and the Western Hemisphere.

The questions put forward to the central banks’

authorities range from those related to basic details, like

when the institution was founded, to more specific ones

concerning the payments system, central bank staffing

policies, and the institution’s independence.

Fry, Goodhart, and Almeida complement their

questionnaire-based evidence by gathering time series

economic data mainly from the International Monetary

Fund, the World Bank, and the Penn World Tables.

Table 7.2 synthesises the project’s key findings and lists

the countries comprising the Bank of England Group.


The investigation’s outcomes somehow reinforce the

evidence on the negative link between inflation and

growth –a topic further examined in Chapter 9 and

already discussed in class.

Also, the study’s conclusions corroborate the fact that

central banks dominate the financial system in

developing countries.

Fry, Goodhart, and Almeida also find that central

banks in their sample countries are moving away from

traditional monetary instruments towards a marked-based

monetary policy implementation.

Yet in that process monetary authorities face serious

obstacles, like underdeveloped and inefficient financial

systems, and fiscal dominance.


And despite these positive developments, the authors

assert that central banks in developing countries have

been rather unsuccessful in consistently fulfilling their

key mandate of delivering price stability.


Table 7.1
de Haan and Kooi’s (2000) central bank governors’ turnover rates (TOR)
in developing countries, 1980-1989

Country TO
1 Algeria 0.
2 Argentina 1.
3 Bahamas 0.
4 Bahrain 0.
5 Bangladesh 0.

Table 7.2
Key findings from Fry, Goodhart, and Almeida’s (1996) Bank of England-sponsored study of central banking in 44 developing countries

Bank of England group of 44 developing countries

Africa: Botswana, Gambia, Ghana, Kenya, Lesotho, Malawi, Mauritius, Namibia, Nigeria, Sierra Leone, South Africa, Swaziland, Tanzania,
Uganda, Zambia, and Zimbabwe. Asia: Bangladesh, Brunei, Fiji, Hong Kong, India, Malaysia, Pakistan, Papua New Guinea, Singapore,
Solomon Islands, and Sri Lanka. Middle East and Europe: Cyprus, Israel, Jordan, Kuwait, Malta, Saudi Arabia, and the United Arab Emirates.
Western Hemisphere: Argentina, Bahamas, Barbados, Belize, Chile, Guyana, Jamaica, Mexico, St Lucia, and Trinidad and Tobago.
Topics Key findings
Price stability, monetary expansion and
Inflation and growth are negatively related in the short- and long-run.
output growth
Central banks collect considerable revenues from the inflation tax. Financial repression policies
The central bank and the government have been in place in most countries examined, generating inefficient outcomes. Quasi-fiscal
activities (like rescuing failed financial institutions) led to central banks making losses.
Fixed and managed exchange rate regimes led to a less volatile real exchange rate vis-à-vis floating
Central banks’ external activities
Most countries have moved towards reforming the payments system. There is also a trend towards
deregulating the financial system, but that development demands special attention in terms of
The central bank and the private sector improved supervision. Countries are also working towards developing their money, bond, and
equity markets, and that should eventually contribute to successfully implementing a marked-based
monetary policy.
Rescue operations have mainly been financed using government funds. Central banks in developing
Regulation and supervision
countries have shown less inclination to adopting deposit insurance than those in OECD countries.
A central bank’s size, the skills of its staff, and how it relates to the rest of the government as
The central bank’s status
constitutionally mandated are key factors in explaining the institution’s status.