A number of economists have investigated the relationship between macroeconomic performance and the degree to which central banks are insulated from partisan politics. They have examined the legal and institutional framework within which central banks in different countries operate, and constructed indexes of the extent to which their central banks are independent.

Many researchers have constructed an index of central bank independence. The index is based on various characteristics, such as the length of bankers’ terms, the role of government officials on the bank board, and the frequency of contract between the government and the central bank.

One major finding of recent research is that the more independent a central bank, the better its inflation performance. More independent central banks ensured lower average inflation and less variable inflation. Countries with independent central banks did not have higher unemployment, lower real GDP growth, or larger business cycles.


It seems that the factors which lead countries to have independent central banks also lead them to have low inflation. Perhaps independent central banks do reduce economic growth, but only countries likely to have high economic growth for other reasons are likely to have independent central banks.

Nevertheless, at least the post-1950 experience of the industrialised countries strongly suggests that insulating central banks from partisan politics delivers low inflation without any visible macroeconomic cost. Most central bank independence appears to be systematically associated with lower inflation.

In India, the RBI is a government organisation like any other public sector unit. At present it does not enjoy the power to formulate and conduct an independent monetary policy. This is why control of inflation has become difficult throughout the plan period. The effectiveness of the RBI’s monetary policy is lost due to the present monetary fiscal link. Such link is established through the government budget constraint which is expressed as

G = T+ B + dM


where G is government expenditure, B is market borrowing, i.e., borrowing by the Government of India by selling bonds, and dM is increase in money supply caused by government of India borrowing from the RBI.

As and when a fiscal deficit cannot be covered by additional taxation or market borrowing the government of India is constrained to borrow from the RBI either against accumulated foreign exchange reserves or by issuing T-bills. (Of course, the practice of issuing ad hoc T-bills has been discontinued in India recently).

No doubt the RBI has been imposing strict controls on the member banks so that they cannot lend beyond limits. But the RBI is constrained to make loan to the government of India as and when there is need for monetisation of fiscal deficit.

Thus, unless the RBI is made an autonomous institution—free from government intervention and control, it will not be possible to hold the price line. The reason is that inflation is like a sin. Every government denounces it and every government practices it. And there is only one place where inflation is manufactured, viz., New Delhi!


As things stand today, the success of India’s monetary policy depends on the success of fiscal policy due to the present monetary-fiscal link. And this enables the government of India to indulge in inflationary financing of its fiscal deficit.

And this painless method of financing its expenditure overheats the economy because the RBI is not able to follow Milton Friedman’s famous monetary rule—money supply has to grow exactly at the rate at which the GDP and other key macroeconomic variables are growing—but is always conducting its monetary policy on the basis of the discretion of the government of India.

Thus the only way to control inflation in India at present is to snap the link between monetary policy and fiscal policy. This will become a reality if—and only if—the RBI is made an autonomous institution, free from all types of government control. Even in his farewell speech, the former Governor of the RBI, Dr. Bimal Jalan, hinted at the same scheme — RBI autonomy — to achieve price stability (which is the cornerstone of the current year’s budget) without compromising with the much needed growth.

Researchers have shown that countries that had an independent central bank, such as Germany, Switzerland, and the USA, tended to have low average inflation. Countries that had central banks with less independence, such as New Zealand and Spain, tended to have higher average inflation.

Empirical studies have also shown that there is no correlation between central-bank independence and real economic activity (macroeconomic performance). To be more specific, central-bank independence is not correlated with average unemployment, the volatility of unemployment, the average growth of real GDP, or the volatility of real GDP (i.e., short-run fluctuations in economic activities or business cycles). Central bank independence does not involve any trade-off. Instead, it appears to offer countries a free lunch: it has the benefit of lower inflation without any visible cost.

This finding has led some countries such as New Zealand to give their central banks greater independence. India can take a leaf from the book of New Zealand and go for the scheme in order to provide a framework for achieving monetary stability.