Three Forms of Central Bank Independence

There are three forms of central bank independence in carrying out its function of maintaining currency stability while simultaneously encouraging economic growth. Domestic currency stability is measured by inflation, and external currency stability is measured by the exchange rate.

Firstly, inflation is maintained through a mix of monetary policies to keep a balance between the growth of the money supply and growth in the real sector. The exchange rate is maintained by balancing the growth of the local currency in circulation with the growth of foreign currency circulating in the country.

Secondly, economic growth is encouraged by facilitating the movement of money from one hand to another. The faster and cheaper the transfer of money in the payment system, the greater the multiplier effect on economic growth.

To achieve these two objectives, an independent central bank is required. In general, independent means being autonomous and free from interference by other parties in efforts to maintain currency stability. This means the central bank, in its independence, must coordinate with various parties to maintain currency stability.

The first form of central bank independence is independence in maintaining inflation. Monetary policy must be carried out with precise timing, the right instruments, and the correct quantity. For example, when the fiscal authority implements a fiscal stimulus by adding liquidity to encourage growth, the central bank must allow time (acyclical policy) for the fiscal stimulus to produce a growth multiplier effect, and only then implement monetary contraction (countercyclical policy) when the multiplier effect begins to diminish and starts to disrupt inflation.

In economics, procyclical, countercyclical, and acyclical monetary policies are only effective in providing economic benefits when implemented with precise timing and good coordination with the fiscal authority. Without coordination, procyclical fiscal policy will cancel out countercyclical monetary policy. Likewise, countercyclical fiscal policy will cancel out procyclical monetary policy. Inflation remains guarded, but fiscal costs rise, monetary costs rise, and economic growth stagnates.