MZUMBE UNIVERSITY

SCHOOL OF BUSINESS

PROGRAM: BACHELOR OF ACCOUNTS AND FINANCE IN PUBLIC SECTOR (BAF/PS)

SUBJECT: MACRO ECONOMICS

CODE: 101

TASK: GROUP ASSINGMENT

LECTURER: MADAME SHITIMA C.

SUBMISSION DATE: 28TH OF AUGUST, 2013

GROUP MEMBERS

MWINUKA RITHA A. 1203036/T.12

MAHENGE CATHERINE 1203020/T.12

OWANO VEDASTO T. 1203041/T.12

PASCAL BONIVENTURE 1203043/T.12

LIMU ALLY S. 1203018/T.12

BROWN DERICK 1203073/T.12

NKUSSA HALIMA H. 1203063/T.12

QUESTION;

“Describe the aspects of the STRUCTURE and FINANCING of the Central Bank that gives it
independence from Parliament and the President. Why is Independence a good Idea for a Central
Bank? Make a case FOR or AGAINST Central Bank Independence”.
A Central Bank is “a bank which constitutes the apex of the monetary and banking structure of
its country and which performs as best as it can in the national economic interest, the following
functions:

 The regulation of currency in accordance with the requirements of business and the
general public for which purpose it is granted either the sole right of note issue or at least
a partial monopoly thereof.
 The performance of general banking and agency for the state.
 The custody of the cash reserves of the commercial banks.
 The custody and management of the nation`s reserves of international currency.
 The granting of accommodation in the form of re-discounts and collateral advances to
commercial banks, bill brokers and dealers, or other financial institutions and the general
acceptance of the responsibility of lender of the last resort.
 The settlement of clearance balances between the banks.
 The control of credit in accordance with the needs of business and with a view to carrying
out the broad monetary policy adopted by the state.” (De Kock)1

Examples of Central Banks include: Bank of Tanzania, BundesBank of Germany, and Federal
Reserve of the United States of America, European Central Bank (ECB) etc.

Central Bank Independence

Generally, Central Bank Independence can be defined as an institutional capacity of the central
bank, typically derived from an institutional mandate, to conduct monetary policy free from
directives, instructions and other forms of interferences from the side of government, industry
and other interest groups. Institutional freedom of the Central Bank includes:

 Goal independence

This is to provide the Central Bank with the power to determine its own goal(s) independently. A
single or, at least, clearly defined primary goal of the central bank provides more weighty
grounds for holding the latter accountable. It is argued that multiple objectives, in contrast, can
impede central bank effectiveness, reduce accountability, and complicate the coordination of
economic policies with the government (Lybek, 2004).

1
De Kock`s definition of Central Bank is prescribed by Dr. M. L. Jhingan in his book titled “Principles of Economic”
as the broadest definition.
  Instrument independence

Refer to the Central Bank’s ability to use the full range of monetary policy instruments without
restrictions from the core executive body. A central bank should have sufficient authority to
determine the adjustment of its monetary policy instruments within the constraints stipulated by
its objectives and the autonomy delegated to it.

 Legal independence

The independence of the central bank is enshrined in law. This type of independence is limited in
a democratic state; in almost all cases the central bank is accountable at some level to
government officials, either through a government minister or directly to a legislature. Even
defining degrees of legal independence has proven to be a challenge since legislation typically
provides only a framework within which the government and the central bank work out their
relationship.

 Management independence

The central bank has the authority to run its own operations (appointing staff, setting budgets,
and so on) without excessive involvement of the government. The other forms of independence
are not possible unless the central bank has a significant degree of management independence.
One of the most common statistical indicators used as a proxy for central bank independence is
the "turn-over-rate" of central bank governors. If a government is in the habit of appointing and
replacing the governor frequently, it clearly has the capacity to micro-manage the central bank
through its choice of governors.

Organizational Structure

The Central bank achieves greater independence through a structure that insulates the governors
from political pressure (appointment to long terms 5 years in Tanzania, 14 years in USA).
Taking USA as an example, since it`s Fed governors cannot be removed from office, nor can
they be reappointed, they feel little political pressure. If the president doesn`t like what they do,
tough luck, until their appointments expire or one of them decides to resign or retire. So while
these governors are at the Federal Reserve, they can pretty much follow the policies they believe
are best without being concerned about political retaliation, even if their terms aren`t for life.

In most of less developed countries, such as Tanzania, the independence of the Central Bank is
somehow impaired as there is much political influence and interference in the activities and
functions of these central banks. For example, Section 8 (i) and (iii) of the Bank Act of
Tanzania (2006) provides that: “The President of the United Republic of Tanzania shall appoint
the Governor and the Deputy Governors for a term of five years and they are eligible for re-
appointment for a further term. The President can also dismiss them for a good cause or
disqualification.” Now due to the fear of being chased out of the office or not being re-appointed
to continue with their work, these governors may work in favor of the President who appointed
them for instance in the period of general election they are forced to help the government by
conducting expansionary policy in order to increase money supply in the economy and to
exercise contractionary policy soon after election in order to reduce the rate of inflation which
was caused by expansionary policy as a result of political interests in the election period. The
interference of the Central Bank`s functions and activities results in the under achievement of
long term goals and objectives of the Central bank. Price stability is the primary objective of the
Central Bank of Tanzania and many other countries.

Financing of the Central Bank

The Central Bank finances its own operations without the need for parliamentary appropriation.
The Central Bank funds its own operations through the profits from trading and holding Treasury
securities and through revenue from discount loans so it does not depend on the parliament for its
funding.

The Central Bank of Tanzania has a complete autonomy over its budget, hence able to pursue its
own objectives. The Bank’s policy and budget are approved by the Bank’s Board of Directors.
The Law provides for access to the Bank’s credit by the Government. However, there is a credit
ceiling.

In the USA, the Fed has much more independence than most agencies due to the fact that
creating money is profitable, and while the Fed returns its income to the Congress, it is not
dependent on Congress for appropriation.

Why is Independence a good idea for a Central Bank

Central bank independence is associated with benefits that are described by Grilli, Masciandro
and Tabellinini (1991)2 in the following way: “Having an independent central bank is almost
like having a free lunch; there are benefits but no apparent costs in terms of macroeconomic
performance”.

Central Bank Independence is an institutional instrument for optimizing the contribution of

monetary policy to attaining the overall goal of steering the economy along a path of high (long-
run) growth of real GDP, high employment rates, and low volatility of these variables (i.e.
stabilization against adverse supply and demand shocks). The basic theoretical argument for
Central Bank Independence is that high long-run economic growth requires price-level stability,
and that independent central bank has less incentive to inflate than the government and enhances
fiscal responsibility of the latter.

The case for Central Bank Independence

2
Central Bank Independence, Accountability and Transparency: The Case of Ukraine
Broad consensus has emerged among policymakers, academics, and other informed observers
around the world that the goals of monetary policy should be established by the political
authorities, but that the conduct of monetary policy in pursuit of those goals should be free from
political control. This conclusion is a consequence of the time frames over which monetary
policy has its effects. To achieve both price stability and maximum sustainable employment,
monetary policymakers must attempt to guide the economy over time toward a growth rate
consistent with the expansion in its underlying productive capacity. Because monetary policy
works with lags that can be substantial, achieving this objective requires that monetary
policymakers take a longer-term perspective when making their decisions. Policymakers in an
independent central bank, with a mandate to achieve the best possible economic outcomes in the
longer term, are best able to take such a perspective.

In contrast, policymakers in a central bank subject to short-term political influence may face
pressures to over stimulate the economy to achieve short-term output and employment gains that
exceed the economy's underlying potential. Such gains may be popular at first, and thus helpful
in an election campaign, but they are not sustainable and soon evaporate, leaving behind only
inflationary pressures that worsen the economy's longer-term prospects. Thus, political
interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to
both a less stable economy and higher inflation.

Undue political influence on monetary policy decisions can also impair the inflation-fighting
credibility of the central bank, resulting in higher average inflation and, consequently, a less-
productive economy. Central banks regularly commit to maintain low inflation in the longer
term; if such a promise is viewed as credible by the public, then it will tend to be self-fulfilling,
as inflation expectations will be low and households and firms will temper their demands for
higher wages and prices. However, a central bank subject to short-term political influences
would likely not be credible when it promised low inflation, as the public would recognize the
risk that monetary policymakers could be pressured to pursue short-run expansionary policies
that would be inconsistent with long-run price stability. When the central bank is not credible,
the public will expect high inflation and, accordingly, demand more-rapid increases in nominal
wages and in prices. Thus, lack of independence of the central bank can lead to higher inflation
and inflation expectations in the longer run, with no offsetting benefits in terms of greater output
or employment. 

Additionally, in some situations, a government that controls the central bank may face a
strong temptation to abuse the central bank's money-printing powers to help finance its
budget deficit. Nearly two centuries ago, the economist David Ricardo argued: "It is said that
Government could not be safely entrusted with the power of issuing paper money; that it would
most certainly abuse it. There would, I confess, be great danger of this, if Government, that is to
say, the ministers were themselves to be entrusted with the power of issuing paper
money." Abuse by the government of the power to issue money as a means of financing its
spending inevitably leads to high inflation and interest rates and a volatile economy.
These concerns about the effects of political interference on monetary policy are far from being
purely theoretical, having been validated by the experiences of central banks around the world
and throughout history. In particular, careful empirical studies support the view that more-
independent central banks tend to deliver better inflation outcomes than less-independent central
banks, without compromising economic growth. In light of all these considerations, it is no
mystery why so many observers have come to see central bank independence as a critical
component of a sound macroeconomic framework, and economists have studied a variety of
approaches to enhance the independence and credibility of monetary policymakers.

Conclusive Remarks

International organizations such as the World Bank, the Bank for International Settlements (BIS)
and the International Monetary Fund (IMF) are strong supporters of central bank independence.
This results, in part, from a belief in the intrinsic merits of increased independence. The support
for independence from the international organizations also derives partly from the connection
between increased independence for the central bank and increased transparency in the policy-
making process. The IMF's Financial Services Action Plan (FSAP) review self-assessment, for
example, includes a number of questions about central bank independence in the transparency
section. An independent central bank will score higher in the review than one that is not
independent.
REFERENCES

 LITERATURES

Jhingan M. L (2009), “Principles of Economics”, Vrinda Publications (P) Ltd, India

David C. Colander (2004) “Economics (Fifth Edition)”, McGraw Hill Companies, New York,
United States of America.

 LEGISLATION

The Bank of Tanzania Act (2006)

 JOURNALS, SPECIAL PAPERS & ARTICLES

Alex Cukierman (1993) “Central Bank Independence, Political influence and macroeconomic
performance: A survey of recent development”

Gerhard Schwödiauer, Vladislav Komarov and Iryna Akimova (2006) “Central Bank
Independence, Accountability and Transparency: The Case of Ukraine”

The Bank of Tanzania (BOT), “Tanzania mainland’s 50 years of independence: A Review of the
Role and Functions of the Bank of Tanzania (1961—2011)”

John B. Taylor (2013), “the Effectiveness of Central Bank Independence versus Policy Rules”,
Stanford University, United States of America

Guy Debelle & Stanley Fischer, “How Independent should a Central Bank be?”

Speech by Ben S. Bernanke, (Chairman: Board of Governors of the Federal Reserve System)
“Central Bank Independence, Transparency, and Accountability”

 WEB LINKS

http://en.wikipedia.org/wiki/Central_bank

http://www.bot-tz.org/AboutBOT/BOTFunction.asp

http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm