The independence of the central bank is important because its objectives differ from those of the government. While the government seeks higher short-term growth and is willing to tolerate higher inflation to achieve it, the central bank aims to keep inflation low and stable, thereby supporting higher, more sustainable long-term growth.
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A common feature of modern central banks is their independence from the government. This autonomy is justified because the goals of the government and the central bank can differ. Typically, governments prioritize short-term growth and therefore favor low interest rates to boost demand and ease debt financing, even if this, in the long term, leads to higher inflation and may harm economic growth. On the other hand, central banks with macroeconomic stability mandates have an interest in low, predictable inflation that ensures the highest possible long-term growth. An environment characterized by high and volatile price increases complicates companies’ decisions about how much to invest and in which sectors of the economy to produce, with a consequent adverse impact on long-term economic growth.
The 2023 book Ensayos de historia económica. Cien años del Banco de la República (Transl: Essay on Economic History. One Hundred Years of Banco de la República), published by the Bank for its centenary, features a chapter by Luis Jácome and Samuel Pienknaugura. They examine the evolution of central bank independence and inflation across Latin American countries. Their analysis uses a central bank independence index (CBI), which can be calculated for any country at any given time.
This CBI index weights four variables identified in the economic literature to assess central bank independence: (i) the legal mandate of the policy objective; (ii) the governance structure of the central bank and its formal independence; (iii) the powers to control monetary policy vis-à-vis the government; and (iv) the conditions for financing public expenditure by the central bank. A central bank with a clear legal mandate for price stability, formal independence (in law and the Constitution), the ability to autonomously control monetary policy, and no role in financing the government’s budget through money issuance is largely correlated with greater independence and a better position to maintain a low inflation rate. Consequently, the higher the index, the greater the central bank’s independence.
Graph 1, taken from the relevant chapter, illustrates the relationship between the average CBI independence index and the average annual inflation rate for a sample of 17 Latin American countries from 1922 to 2021. It reveals a negative relationship between the central bank independence index and inflation. Namely, countries with higher indices of central bank independence have lower inflation. A more detailed statistical analysis based on individual country data confirms this negative relationship.
Graph 1: Inflation1 and Central Bank Independence in Latin America (1922-2021)
Source: Central bank legislation: central bank mandates, amendments to relevant laws, and constitutional provisions. Inflation: international financial statistics and IMF World Economic Outlook, year-end data.
The authors identify three key historical periods in the data, as shown in the Graph. The first period, which extends from 1922 to 1945, is characterized by adherence to the gold standard, which maintained monetary policy independent from the government and kept inflation relatively low. The second, labeled “growth-focused”, lasted until 1990, during which central bank independence gradually declined, resulting in high inflation and hyperinflation in some countries. The final period, starting after 1990 and called “stabilization”, saw a significant increase in central bank independence and a drop in inflation to low, stable levels, except for the global inflation spike following the pandemic.
Overall, the assessment results corroborate the strong correlation between central bank independence and low inflation. This aligns with economic theory and should serve as a basic tenet in shaping the country’s economic policy institutions.
1 ↑ Inflation is measured as the average of the logarithms of countries’ inflation rates, using log(inflation + 1). A logarithmic scale helps with visualization, especially since over several years, many countries in the sample saw annual inflation rates exceeding 1000%. .
