Qualities of effective central banks

An effective central bank must have three core qualities: independence, credibility, and transparency.

Independence

Since politicians have an incentive to keep inflation rates too low in the run-up to elections, it is important to delegate monetary policy to an institution that is immune to these cyclical pressures. Hence, central bank independence is critically important. Some banks have both operational and target independence, such as ECB, which means that they can set whatever inflation level, index, etc. using whatever tools they deem appropriate, but others are independent only operationally, i.e. the independently implement policies aimed at a target set by the government, such as the central bank in the UK.

Credibility

Independence of a central bank and public confidence are critical for the credibility of the central bank. If a bank is influenced by a government, and the government has very high debt, the government may have a strong incentive to increase inflation so as to reduce its burden of debt in real terms. This might hurt the credibility of any stated target inflation. However, if people believe a central bank, the inflation target may become self-fulfilling.

Transparency

Credibility is reinforced through transparency. Independent central banks which periodically publish inflation reports highlighting their assessment of different indicators in an economy and offering projection, have higher credibility and are more successful in implementing their inflation targets.

Test

In order to achieve transparency to earn credibility and make it’s inflation-targeting successful, a central bank should:

  1. Publish regular assessments of their economies in the form of inflation reports.
  2. Encourage its Chairman and Board of Governors to appear on mainstream media to communicate their policy decisions.
  3. Establish and publish a quantitative rule that automatically changes with changes in economic variables.


Show answer

A is correct. Inflation reports provide economic agents with information on what data series central bankers look at, which enables them to understand how monetary policy would affect the economy. This increases transparency and credibility. B is incorrect because requiring board members and Chairman to appear on mainstream media may politicize and dramatize the process. C is incorrect because it would be too inflexible a rule.

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