This essay will focus on exploring the ongoing long debate on whether government officials should

have power to influence interest rates and economic growth, or whether central banks should be
granted complete independence in these matters.

It is often argued that a politician cannot be completely trusted . In the political business cycle model
( Nordhaus (1975)) politicians attempt to lower the unemployment rate before elections to raise
their chances of re-election. Voters reward politicians for higher growth during election years &
value growth more than other economic objectives such as low inflation & higher employment.
Politicians are willing and able to manipulate policy to exploit this short-run non-neutrality for their
own benefit, while the macroeconomic policy is not neutral (at least in the short run) and therefore
can alter economic outcomes. In such case if more people get employed, they will contribute further
to the total demand of any economy, resulting in a higher price level; that is, inflation. Then once the
politicians win the election, they will lower the interest rates to control the said inflation (Andrade et
al. 2018). In most cases it is shown that the ability of politicians to effectively coordinate interest
rates, taxes, and economic growth is often a subject of skepticism among citizens. Literatures and
successful experiences of central banks accumulated consensus that granting central banks
instrument independence to conduct monetary policy, while holding them accountable to a well-
defined and limited price stability mandate, can improve their policy efficacy by insulating them from
political pressures looking to exploit short-term trade-offs between inflation and employment. ( The
case for central bank independence)

In most domains of public policy, including monetary policy, independence is seldom absolute or
binary, and is typically subject to both ex-ante constraints on decision-making and ex-post
accountability mechanisms. Delegated decision-making in democracies is typically accompanied by
checks and balances, which serve to ensure that decision-makers act in the public interest and are
held accountable for their actions. While independence is subjective, Central bank independence is
no exception which has been up for debate for the last few decades. It is clearly valuable for
ensuring that monetary policy is conducted in a way that is consistent with appropriate central bank
objectives and free of political influences. Nevetherless, CBI has been under attack in both the
developed & emerging markets. The arguments regarding CBI are focused on the monetary policy
role of central banks that emerged in the post-World War II era as economists began to understand
the importance of interest rates and credit aggregates to the macroeconomy. Historically, central
banks, including some that were private-sector entities, were explicitly agents to carry out
government policy (Parkin and Bade 1978). The key critiques also raised against central banks
independence due to their policy response & financial crisis during the Global Financial Crisis (GFC)
in 2007 .
However, The relationship between inflation and growth became recognized in the latter part of the
20th century, with Friedman and Phelps highlighting the consequences of monetary expansions to
achieve a lower unemployment rate than natural, resulting in an inflation bias. While the Phillips
Curve explains how lower unemployment can lead to increased demand, causing product prices to
rise and resulting in inflation. However, in the long run, excessive money supply leads to an inflation
bias, hindering economic growth and encouraging businesses to increase salaries rather than hire
new employees. This is where the central bank comes to light, and their independence attains great
significance.

The purpose of this essay is to explore the answer to the question of whether the
management of interest rates would be better served by the intervention of the
government or if central banks work independent coordination. According to
research, lower inflation can be achieved with minimal government influence, and the
effectiveness of interest rates increases when set independently . While the
government may be tempted to prioritize short-term economic growth over long-
term inflationary consequences, the central bank's primary goal is to maintain
economic stability, which aligns with the long-term economic environment
Therefore, it can be argued that coordinating interest rate control through the
central bank would better serve the long-term interests of both the economy and the
country

The relationship between inflation and growth is complex and depends on several factors. In the
short run, there may be a negative relationship between inflation and unemployment, as described
by the Phillips curve. However, in the long run, this relationship does not hold, and monetary
expansions aimed at achieving lower unemployment can result in an inflation bias that harms
economic welfare. Theoretical models by Friedman and Phelps showed that workers and employers
adjust their behavior based on their expectations of future inflation, resulting in higher nominal
wages but no increase in employment. Anticipated inflation still imposes economic costs, such as tax
distortions and "shoe-leather" costs. Uncertainty about future inflation carries additional costs, such
as income and wealth redistribution from creditors to debtors, misallocation of resources, and
discouragement of long-term contracts and investment.

Empirical studies have found a significant negative relationship between inflation and output in the
long run, with inflation and high variability of inflation reducing total factor productivity, investment,
and real GDP per capita. Therefore, achieving and maintaining price stability is important for higher
levels of output and employment. Central bank independence is important in the context of the
relationship between inflation and growth as it allows the central bank to pursue a consistent and
credible monetary policy aimed at achieving and maintaining price stability. As noted above,
expectations play a crucial role in shaping the behavior of economic agents in response to inflation,
and a central bank with independence from political influence is better positioned to anchor those
expectations and prevent them from becoming unanchored, which can lead to higher inflation and
economic costs. While both legal (de jure) and actual (de facto) independence increased in most
central banks in the world during the late 1980s and the 1990s (Crowe and Meade (2008),
Cukierman (2008)), the levels of inflation were also reduced in many countries. In one of the first
studies, Alesina and Summers (1993) found a near-perfect negative correlation between inflation
and legal central bank independence in the 16 OECD countries included in their sample. In this study
it was also found that central bank independence reduced inflation variability, but had neither large
benefits nor costs in terms of real macroeconomic performance. These results were consistent with
other studies conducted at that time (Cukierman (2008).

Governments had a natural tendency to over-inflate their economies, especially around election time, generating
an “inflation bias”. To curb bias, monetary policy decisions were to be delegated to a “conservative”, inflation-
minded, central bank acting independently from government. Empirical evidence suggests, during the 1980s and
1990s, a statistically significant link between the level and variability of inflation and the degree of central bank
independence across a range of countries. These cross-country correlations strongly suggested central
Independence was an important contributor to reduced inflation bias. It confirms the negative, statistically
significant, relationship between (the level and variability of inflation) and independence. Evidences also
suggests, independence did not result in an increase in output variability. Taken together this evidence implies
independence has, indeed, been a twin-win. There are further evidences which supports independence has ….
Central bank independence enhances the credibility of monetary policy. If the central
bank is independent, it is more likely that its decisions will be perceived as being
based on economic analysis rather than political considerations. This enhances the
credibility of the central bank and the effectiveness of its policies. In the early 1990s,
New Zealand faced high levels of inflation and weak economic growth. In response,
the government implemented a series of economic reforms, including granting the
RBNZ operational independence in 1989. The RBNZ was given the responsibility for
maintaining price stability and was required to set an explicit inflation target.

Since then, the RBNZ has consistently pursued a monetary policy framework focused
on achieving its inflation target through interest rate adjustments.

The RBNZ's independence has been crucial to maintaining the credibility of its
monetary policy. The RBNZ's decision-making processes are guided by economic
analysis, and its policy decisions are not subject to political influence.

Central bank independence is often cited as a key factor in promoting

macroeconomic stability. Inflation and deflation can have significant negative
impacts on the economy, such as reducing consumer and investor confidence,
creating economic uncertainty, and destabilizing financial markets. Central banks
play a critical role in managing inflationary and deflationary pressures through their
monetary policy tools, such as adjusting interest rates, managing the money supply,
and implementing quantitative easing programs. Alesina, A., & Summers, L. H. (1993).
Central bank independence and macroeconomic performance: Some comparative
evidence. Journal of Money, Credit, and Banking, 25(2), 151-162.

Central bank independence promotes accountability by making the central bank

more transparent and accountable to the public rather than to the government. This
enhances public confidence in monetary policy and promotes greater trust in the
central bank's decision-making processes. Moreover, central bank independence can
promote transparency and accountability by encouraging the central bank to
communicate its policy decisions and strategies clearly and effectively to the public.
This can increase public understanding of monetary policy and improve public
participation in policy discussions, which can in turn enhance the credibility and
effectiveness of the central bank. Another outcome that can be achieved which is
reducing inflation bias by keeping central bank accountable. As per Walsh's model,
which proposes a contract between the government and the central bank to
establish an inflation target and give the central bank instrument independence to
achieve it. The contract includes penalties and rewards to hold the central bank
accountable for meeting the inflation target. Walsh, C. E. (1995). Optimal contracts
for central bankers. American Economic Review, 85(1), 150-167. An

explicit inflation target raises the central bank’s accountability in controlling inflation

while, at the same time, providing a constraint on discretionary policy, thereby

reducing the political pressure to pursue inflationary surprises and the likelihood of
time-inconsistent policymaking (Mishkin (2006)).

Most important factor which support the Central bank independence is that
it promotes a long-term focus. Central bank focuses on its mandate of price
stability over the long term rather than being short-term interest like of
politicians. The outcome of Monetary policy decisions are based on a
comprehensive and objective analysis of economic data to achieve long
terms goals rather than political considerations. Also, central banks are better
equipped than politicians to make decisions about monetary policy due to their
expertise and technical knowledge. In practice, this often involves the appointment of
technocrats to lead central banks.

Central bank independence can enhance international competitiveness by promoting

monetary stability. According to research, countries with independent central banks
have lower inflation rates which can enhance their international competitiveness As
per Bade and Parkin (1988), the average rate of inflation was significantly lower in countries with more
policy-independent central banks (i.e. central banks with stronger institutional independence). Similarly,
Grilli et al. (1991) found a significant negative relationship between inflation and economic independence in
periods of high inflation, while political independence was significant only in the 1970s (see Table 1). 20 In a
similar vein, Debelle and Fischer (1994) found better inflation performance in central banks where a
mandate for monetary stability was combined with instrument independence.

The modern view why Central Bank must often work with or listen to political authorities.

The Global Financial Crisis contributed to reopening a debate on the precise scope and desirability of Central Bank
independence, particularly with regard to monetary policy. Insofar as monetary policy is concerned, it is still
widely accepted that the policy tools should be set by a policy committee that is independent of
political influence. But even then, monetary policy might have political implications. For example, at
the zero lower bound, asset purchases by the central bank
can have distributional impacts that can involve political choices. However, the regulatory, lending,
and stability functions of the central bank came to the forefront very quickly during the financial
crisis. Crisis responses—whether to intervene and support institutions—have distributional
implications and also involve fiscal expenditures. These are inherently political decisions that should
not be left to unelected bodies. Independence is further endangered by the fact that the crisis pushed
central banks into making choices with lasting distributional consequences. By making massive
purchases of government bonds, quantitative easing has held both short- and long-term interest rates
low for a very long time. While this may have helped to stimulate declining economies, it has done so
by making rich owners of financial assets richer still. At the same time, poorer savers relying on bank
deposits have been getting next to nothing. Recent developments could be a watershed in the public
approach to central banks, particularly in countries where the sensitivity to income distribution
changes is high. The public may not tolerate leaving decisions with important distributional and fiscal
consequences (such as those related to bank resolutions) to
unelected bodies. During policy making, there are a lot of cases when policies require government
inputs. Thus, it is not possible for the CBI to maintain its boundaries then. In certain cases, It is
debated that if the commercial banks get a higher lending and lower collateral along with the
purchase of non-traditional assets, then there will be a risk loom above the states’ consolidated
balance sheets.

Hence the above arguments suggests central banks must consider the political implications of their
actions. It implies that central banks should not work independently on issues that have
significant distributional and fiscal implications and should be mindful of their political
responsibilities.

Conclusion
Central bank independence rested on four principles – time inconsistency, technocratic legitimacy,
epistemic community and distributive ambiguity (Jones (2019). Together, these principles help to
reduce the political influence on monetary policy decisions and allow central banks to focus
on achieving their objective of price stability. By doing so, central banks can promote
macroeconomic stability and sustainable long-term economic growth.
The debate on central bank independence (CBI) has been ongoing since the mid-
20th century, with proponents arguing that independence can lead to better
performance and outcomes. Despite some criticisms, there are several advantages to
CBI. However, it may take some time to reach a consensus on this issue. In the
meantime, it is important to allow central banks to operate according to the needs of
their respective economies.

One of the advantages of CBI is that it can help central banks achieve a better
balance between stabilizing output and controlling inflation. While there may be
some trade-offs between these goals, an independent central bank can make
decisions based on its technical expertise and economic knowledge, without being
influenced by short-term political considerations. By doing so, central banks can
promote long-term economic growth and stability.