3.2. Why does the relationship exist?
Maybe, the most significant difference between the decision made by the Central Bank and the Central Government should be referred to the emphasis on long-term or short-term interest. Numerous episodes in the world’s economic history testify to a government’s potential abuse of its power to create money. Much the same has happened all too frequently with paper money systems. Many governments have given way to the temptation to reduce interest rates ahead of elections. This may boost spending and employment in the short term, and then a short period of ostensible boom will appear. However, that will not last for long and, ultimately it usually also causes higher inflation over the following several years, which will lead to a worse economic condition. Only those countries with economic capacity which can meet this higher level of demand can avoid the unpredictable inflation. What makes it more difficult to control is that the higher inflation, however, only becomes apparent a couple of years later. An elected government concerned about its immediate popularity might be tempted to go for the short-term gains from lower interest rates, finally, leading to higher inflation some day. That is why a dependent Central Bank will be confronted with higher inflation rate.
On the other hand, those more independent Central banks are projected to perform better, since they can resist the pressure to make short-term policy decisions that are at odds with their long-term objectives. Charles T. Carlstrom and Timothy S. Fuerst (2006) put forward the argument that Central banks gain independence chiefly through institutional reforms such as long-term appointments for central bank governors, for example; explicit inflation targets; and a combination of institutional reforms and targeting. The element common to both inflation targeting and central bank independence is constraint of the fiscal authority’s behavior. Thus, it is more likely for these institutions to achieve lower inflation target.
3.3.The Exception of Japan
It is widely acknowledged that the Bank of Japan is a Central Bank which closed depends on its Central Government. In other words, it is the Ministry of Finance in Japan that has the obligation to conduct monetary policy. Nevertheless, Japan experiences an excellent inflation record. Some economists consider Japan as an exception of the universal rules for the negative correlation between CBI and inflation. What leads to this?
Here a simple but classical model, Barro-Gorgon framework(1993) should be incorporated into our analysis to illustrate how a wonderful political institution may affect low and stable inflation. In the words of Walsh (1997), Barro-Gorgon model, which reflects that the equilibrium inflation rate under a discretionary policy regime equal to Î±Îº/Î². More precisely, Î± stands for the effect of real output on inflation rate. It had been proved by Walsh(1995) that Japan was one of the countries which had the lowest value of Î±. Then comes to Îº, which presents the unemployment rate . The low unemployment rate in Japan is a key point leading to its low inflation. Finally, Î² had been defined as the parameter weight on the policy maker’s preference function. Only this one has been taken into account in our analysis in the previous section, which reveals the negative correlation between CBI and inflation rate on another ground..
Based on the statement above, apart from CBI, there are other contributing factors playing crucial roles in supporting a low-inflation environment. Hence, it is not surprising that Japan experience lower inflation, which can be attributed to reputational considerations of the government.
With the trend that an increasing number of countries impose the independence to their Central Banks, the Central Bank would have more autonomy when they formulate monetary policy. Although there is an evident negative correlation between CBI and inflation rate, there are still some exceptions (such as Japan), due to some other factors which will contribute to inflation rates, including growth rate and unemployment.