Independence of Central Bank (10%)

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Independence of Central Bank (10%)

Central Bank independence is one of the key pre-requisites for effective inflation targeting.

Kahn (2009) states that although monetary policy goals must be set by the democratic government, their implementation should be the mandate of the central bank to avoid the time-inconsistency problem or a political monetary policy cycle. This mandate may not be made into a law, but what matters is past credibility and a continued commitment to the goal of price stability. On other hand, Charles Freedman et al (2010) argues that legislating this mandate is important, particularly in emerging economies where there is a history of government control of monetary policy. For example, the government may resort to populist measures and change the target when central bank has to take unpopular steps. This takes away the basic advantage of inflation targeting- anchoring expectations and increasing predictability and credibility (Kahn, 2009).

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Guy Debelle et al (1998) argues that fiscal policy must not dominate or dictate monetary policy. This means:

  1. Very low or no borrowing by government from the central bank
  2. Well-developed domestic markets that can absorb public debt (e.g. treasury bills)
  3. Broad base of government revenue so that there is minimal dependence on seigniorage revenues

In presence of fiscal dominance, fiscal policy based inflationary pressures will reduce the effectiveness of inflation targeting as central banks will be forced to accommodate government demands such as lowering interest rates to aid fiscal goals.

To avoid discretion by governments with regards to monetary policy, transparency and strong communication are important in central banks. In South Africa, monetary goals are set by government by setting the target while constitution guarantees instrument-independence of central bank. (Kahn, 2009)

Limitations ofInflationTargeting(10%)

  1. Limitation in analyzing its effectiveness is since it is difficult to differentiate between the overall impact of general economic reforms and the more specific impact of inflation targeting. Sarwat Jahan (no year)
  1. According to CA Sims (2003) “Inflation targeting may do more harm than good if there is a substantial chance that the central bank cannot in fact control inflation”. This implies that in countries with history of inflation control problems, usefulness of inflation targeting may be limited. Alan Bollard (2008) in his speech said that “Inflation targeting is not an elixir for stabilization. Independence and accountability arrangements for central banking lead to heightened expectations of what monetary policy is actually able to achieve.” So,

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