Benefits of Central Bank Independence

Monetary Policy used to be the preserve of the Government. The Government would change interest rates to meet its various economic objectives. At different times the Government would give priority to:

• lower inflation
• Higher growth
• Targeting exchange Rate
• and even balance of payments.

For example, in the early 1980s, the Thatcher Government increased interest rates to reduce inflation.
In 1987, after a stock market crash, interest rates were cut to boost economic growth. In 1992, interest rates were increased to 15% to try and maintain the value of the £, which was then in the Exchange Rate Mechanism ERM

Arguments for Central Bank Independence

1. It was argued that the governments tended to make poor decisions about monetary policy. In particular they tended to be influenced by short term political considerations.
2. Before an election, the temptation is for a government to cut interest rates. This increases economic growth, reduces unemployment and increases the political support of the party. However, this expansionary monetary policy may lead to inflation and boom and bust economic cycles. Therefore arguably, it is better to take monetary policy out of government’s hands.
3. People have more confidence in the Central Bank, therefore this helps to reduce inflationary expectations. In turn this makes inflation easier to keep low.

Bank of England’s Independence 1997

In 1997, the Labour party gave the Bank of England full independence in setting Monetary Policy. However, the government did give the Bank of England an inflation target of RPI 2.5% +/-1 (now CPI 2% +/-1)

If the inflation rate goes outside this range the Bank of England has to write an explanatory note to the chancellor.

• UK Monetary Policy
  
• An Evaluation of the MPC in controlling inflation