.
The increased independence of central banks is given so that the monetary policy credibility (reputation) is increased. The importance of credibility to the monetary policy was realised in the mid 1980s. As Barro and Gordon (1983) stated "the time inconsistency arguments were combined with rational expectations to show that discretionary monetary policy was ineffective for raising real output, as private actors factored inflation into their expectations creating an inflationary bias in society". Thus, authorities needed a tool that could be used to increase the credibility of the monetary system price stability for the public. The public had a "generalized distrust of politicians of all shapes and sizes" C Goodhart (1995), which increased the popularity of the birth for central banks having independence. By having CBI the government tied its hands to an anti-inflationary policy, thus increasing its credibility. Credibility was increased by how transparent the central bank was (published minutes of central bank meetings, regularity of central bank reports) and the type of contract between the two parties (Walsh et al 1995) allowing for an override mechanism (three types: the right to issue instructions, the right to approve, suspend, annual or defer decisions, and the right to censor decisions on legal grounds (De Hann 9999)), where the government in the case of a shock could takeover the monetary policy decision making (Lohmann 1992). The decision to increase independence to central banks was preferred to that of trying to better the reputation, as it was time consuming and costly.
It is argued by De Hann et al (1999) that an independent central bank can give full priority to low levels of inflation, whereas countries with a less independent central bank other considerations may interfere with the price stability objective. CBI makes a monetary policy directed towards low levels of inflation more credible.
