Central Bank Independence and the Conduct of Monetary Policy Essay

Central Bank Independence and the Conduct of Monetary Policy - Essay Example During the period of 1970s and in the beginning of 1980s, main industrialised economies witnessed constant stage of increased inflation (Walsh, 2005). A central bank that is independent enjoys freedom while planning its instrument of policy in order to attain its purpose. In order to have functional independence, it is necessary for the main purpose of the nationwide central bank with regard to a state which is a member of the EU, to be planned in a transparent and lawfully certain way. It is also required to be completely aligned along with the main purpose of price steadiness (Smaghi, 2007). To be more precise, the concept of central bank independence means that the bank enjoys complete independent authority in planning the degree of short-term rate of interest with regard to the ‘money market’ (Smaghi, 2007). 2. The Central Bank Independence & Framework of Monetary Policy In the earlier years, there have been certain absolute alterations made in the legislation of the central bank in order to boost the legal independence for the bank. The alterations made in the legislation provide more power to the central bank and facilitates it to emphasise chiefly on the purpose of price stability. ... Therefore, it can be stated that the vital purpose of the monetary policy designed by the independent central banks is to uphold stability in prices by effectively managing the inflation (Cukierman, 1994). 2.1. Basic Concepts in Monetary Policy The mechanism of the monetary policy is a process with the help of which alterations in the supply of money have an effect on employment, equilibrium of payments, output and inflation as well. For instance, any increase in the supply of money would imply that there would be more availability of money for the people to expend on assets that are financial in nature. As a result, the cost of the financial assets would increase. It is a known fact that there exists an inverse relationship among the rate of interest and the cost of the financial assets. To further understand this concept, it is assumed that there has been an issue of a certain government bond for ?1000 and which is expected to pay an interest of 10 per cent which makes it ?100. Now , if assumed that the price for that particular bond went up to ?2000 then the interest of ?100 would be now 5 per cent. Therefore, it indicates that an increase in the costs of the financial assets would result in decreasing the interest rates. Decrease in the rate of interest encourages investment along with consumption. They even tend to lessen the requirement for currency by way of lowering the value as well as increasing the export demand and lessening the import demand concurrently (Grant & Vidler, 2000). The main purpose of a central bank is that of defending the worth for the currency with regard to what it would buy. Inflation or rising price decreases the value for money. Monetary