Role of Financial Institutions and the Central Bank in Kenya

Introduction Anti-inflationary policies are the policies taken by the government to announce inflation target lowering it to zero, in the beginning of the year, which at that time is considered optimal. The government wants to keep the inflation level low in an economy. It is the continuous rise in the general price level of goods and services over a period of time in an economy. As we know inflation can cause serious social consequences, if it’s not perfectly anticipated, money as a measure of value or as a medium of exchange is undermined.

The issue of credibility The announcement of the government of anti-inflation will form expectations and be embedded into contracts. Wage contracts are also signed in this period. In this circumstance, the policymaker has a chance to induce a surprise inflation leading to an increase in inflation level and a decrease in the level of unemployment. This may be desirable, particularly if the natural level of unemployment is considered too high from a social point of view, so that during the year a higher inflation would have been optimal.

And as this has been undertaken by the government a number of times, the announcements are not considered credible. The private sector can foresee the consequent move by the government and does not take into account the announcement, since in the past the government induced surprise inflation, although this inducement is not the response to any change in the environment but the change in policy action of the private sector itself. This brings in the time-inconsistency problem, where there are considerable two players, private sector and the policy maker (here, government).

Knowing that the final unemployment rate would be UN, the government choose to minimise inflation by promising to drive down ? to 0. The private sector then predicts the government’s final move and makes a choice regardless of the policy and forces the policy maker to make the final decision at ? > 0, which means accommodating positive inflation with no gain in unemployment level: inflationary bias. And countries with high inflationary bias are said to have the credibility problem as the private sector realise the government’s incentive for inducing surprise inflation.

This lack of credibility leads to an undesirable aftermath. The monetary authority will have to accommodate higher wage pressures and inflationary expectations in order to keep the unemployment level in control. Although, according to the literature by Kydland and Prescott in 1977 the credibility problems occurs when the monetary authorities have the short run incentive to achieve an output or employment target that is above the NAIRU OR market-clearing level. It can even arise in the absence of conflict of objectives between the private sector and policy maker.

The time-inconsistency also arises even if policy maker decides to stabilise the economy at NAIRU but with forward-looking variables like inflation or long-run interest rate or even exchange rate. Solution to time-inconsistency problem The main solution to this time-inconsistency problem causing an inflationary bias, could be a constitutional rule, or a central bank independence combined with an optimal inflation contract (Walsh,1998) or an optimal inflation target (Svensson,1997a). And it is Rogoff who has proposed to delegate monetary policy to an independent and conservative central banker to reduce the inflationary bias.

This meant that inflation stabilisation would be given up for output stabilisation. The numerical analysis below explains how the degree of independence and conservativeness effect the level of inflation. (Berger, Haan & Eijffinger,2000) The policymakers seek to minimise the loss function of the government which is …………………………………………….. …… is output …… is desired output ….. is government’s weight on output stabilization Lucas supply function by which output is driven is …………………………………………….. ….. is actual inflation ….. is expected inflation……is a random shock with mean 0 and variance…

Taking the inflation expectation as given, the policy makers minimise the loss function on a periodic basis. With rational expectations inflation is: ……………………………… The first term on the right hand side is the ‘inflationary bias’ and the second term reflects to the degree to which stabilisation of output shocks influence inflation. If a conservative central banker is charge of the monetary policy the loss function would be ………………………………………………………. ….. is additional inflation aversion of the central banker.

According to Eijffinger and Hoeberichts ( 1998), the money supply can be modelled as: ………………………………… ….. is the degree of central bank independence. So, after minimising government’s loss function, with rational expectations, inflation will be depicted as…………………………………. Comparing the inflation level it can be seen that the inflationary bias is lower for positive values of ….. and …… It does show that lower level of inflation will be achieved by delegating monetary policy to a conservative and independent central bank.

But if the central banker and the government has the same inflation aversion, (? =0) the independence does not matter and in the same way, if the central bank is fully controlled by the government, (? =0) the conservativeness does not matter, unless it is the optimal combination of ? and ?. However, McCallum (1995) criticised this solution of reducing inflation bias. He argued that delegation barely relocates the time inconsistency problem rather than resolving it, since the government can still induce surprise inflation if it changes the terms of delegation.

But, the time inconsistency problem is reduced to some extent if it’s costly to change delegation. Then again the central bank independence is also dependent on the legislators who can change the law. Legislation of a law to create an independent central bank and authorise it to direct its policies to achieve price stability is one of the mechanisms to overcome the incentive problems of monetary policy. Others include the contracting approach, where application of ideas from principal agent literature is the optimal contract.

According to Walsh(1995), an optimal linear inflation contract can eliminate the inflationary bias without distorting the stabilisation policy. And the linear contract can be mapped into an inflation target shown by Svensson(1997). But the problem that occurs with this is that when the inflation is high, the government has no incentive to enforce the contract, it will try to encourage the central bank to be more expansionary when there is high unemployment. According to the empirical evidence it has been seen that central bank independence (CBI) helps to reduce inflation.

Cukierman stated that in industrialised countries, CBI and inflation are negatively correlated although in developing countries the CBI index is not correlated with inflation. The cross-country analysis showed an empirical link between credibility and central bank independence. High degree of CBI is said to be associated with low inflation and the economies do not suffer from above-average output volatility. Although the direction of causality is questioned and Posen(1995) suggested that it goes from low inflation to high CBI rather that the normally assumed ‘high CBI helps to control inflation’.

Societies with a stable economic environment are likely to encourage and support independent monetary institutions which, in turn are more effective in controlling inflation. Although the cross-sectional analysis might show misleading results since it omits country-specific features which might be simultaneously correlated to the degree of independence of the central bank(Muscatelli &Trecroci, 2000). Theoretically the concept of conservativeness in central bank might work, but practically, it seems void because the positions in the governing board of a central bank are not easy to identify and they change term-wise.

Cukierman and Grilli et al. showed that instrument independence effects inflation performance but conservativeness has little or no impact. The emphasis is on the importance of institutions is mixed and the cross-country evidence involves problems of interpretation. Optimal inflation targeting Another measure, inflation targeting can be used to reduce the inflationary bias and many countries has adopted this as their monetary policy regime. It enables the monetary policy to focus on domestic considerations and also is understood by the public and thus highly transparent.

With an explicit inflation target, this regime helps to reduce the chance of the central bank to falling in a time-inconsistency trap. And since time-inconsistency is likely to come from political pressures, the central bank can focus on controlling inflation rather than rising economic growth and the number of jobs through expansionary monetary policy(Mishkin,1999). Friedman and Kuttner(1996) have criticised the regime of inflation targeting because, according to them, it imposes a rigid rule on the policy makers and makes it difficult for them to have discretion in responding to unforeseen circumstances.

But according to Mishkin(1999) useful strategies those are ‘rule-like’ and involve forward looking behaviour, constrains policy makers from undertaking policies with undesirable long-run consequences. Inflation targeting requires that the central bank should use all information available to determine the optimal policy to achieve the inflation target. And it is practised with a substantial degree of discretion. Through its transparency this regime increases the central bank’s accountability, which contains discretion so that it can help to amend the time inconsistency problem.

Conclusions According the evidence provided, we can see that both independence and conservativeness matter for inflation performance, provided that the government cannot change delegation at zero cost. The issue of credibility of policies takes the government’s reputation of an economy at stake and causes the time-inconsistency problem. Pressures from government might force the policymakers to take decisions that lead to reduction in the unemployment level at the expense of high inflation.

If the monetary policy is delegated to an independent and conservative central bank that is more accountable, transparent and free from political pressures it can focus on the long-run goals of an economy which is price stability and set policies accordingly and not change its decisions from time to time for a short-run incentive like reduction in the unemployment level. And thus the credibility issue would not be questioned. The private sector learns about the central bank’s intentions through central bank independence.

And practically the central banks have to adapt to a changing macroeconomic environment and have to act accordingly by changing policy responses if necessary in the uncertain environment. References The papers I have read: • “Central bank independence : an update of theory and evidence” by Helge Berger, Jakob de Haan and Sylvester C. W. Eijffinger(2000). Journal of Economic Surveys, 2000,15, 3-40. • “Monetary policy rules, policy preferences and uncertainty: recent empirical evidence” by Anton Muscatelli and Carmine Trecroci (2000).

Journal of Monetary Economics, 43, 1999, 579-605. • “International experiences with different monetary policy regimes” by Frederic S Mishkin(1999). Journal of Economic Surveys, 2001, 14, 597-627. Ideas and concepts are taken from class presentations of classmates. • Analysis of time-inconsistency problem of optimal discretionary monetary policy • Monetary policy targets and rules: Review of “International experiences with different monetary policy regimes” by Frederic S Mishkin(1999) • Lecture 6: Monetary Policy by Chris Tsoukis.

Statements of different economists have been interpreted in this essay with reference. I did not read the papers of those particular economists the statements were mentioned in the papers I have stated above. • Friedman and Kuttner(1996) • Cukierman and Grilli et al • Posen(1995) • Svensson(1997) • Walsh(1995)&(1998) • McCallum (1995) • Eijffinger and Hoeberichts ( 1998), • Kydland and Prescott(1977) The credibility of anti-inflationary policies can be enhanced by delegating monetary policies to an independent and conservative central bank. Discuss. Name: Onindita Islam Student number: 073601506.