THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 431

CHAPTER 15

Central Banks and the Bank of Canada

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SHO UL D THE BAN K OF CA NA DA BE IN DE PE N DE NT ?
As we have seen, the Bank of Canada is probably the most independent government agency in Canada. Every few years, the question arises whether the independence given to the Bank of Canada should be curtailed. Politicians who strongly
oppose a Bank policy often want to bring it under their supervision in order to
impose a policy more to their liking. Should the Bank of Canada be independent,
or would we be better off with a central bank under the control of the government?

The Case for
Independence

The strongest argument for an independent Bank of Canada rests on the view that
subjecting the Bank to more political pressures would impart an inflationary bias to
monetary policy. In the view of many observers, politicians in a democratic society
are shortsighted because they are driven by the need to win their next election. With
this as the primary goal, they are unlikely to focus on long-run objectives, such as promoting a stable price level. Instead, they will seek short-run solutions to problems, like
high unemployment and high interest rates, even if the short-run solutions have undesirable long-run consequences. For example, we saw in Chapter 5 that high money
growth might lead initially to a drop in interest rates but might cause an increase later
as inflation heats up. Would a Bank of Canada under the control of the government
be more likely to pursue a policy of excessive money growth when interest rates are
high, even though it would eventually lead to inflation and even higher interest rates
in the future? The advocates of an independent central bank say yes. They believe that
a politically insulated central bank is more likely to be concerned with long-run objectives and thus be a defender of a sound dollar and a stable price level.
A variation on the preceding argument is that the political process in Canada
could lead to a political business cycle, in which just before an election, expansionary policies are pursued to lower unemployment and interest rates. After the
election, the bad effects of these policies high inflation and high interest rates
come home to roost, requiring contractionary policies that politicians hope the

public will forget before the next election. Although the issue has not been completely settled, research indicates that there is no credible evidence that such a
political business cycle exists in Canada (see the FYI box, Economics and Politics).
Putting the Bank of Canada under the control of the government is also considered dangerous because the Bank can be used to facilitate government financing of large budget deficits by its purchases of government bonds in the open
market. Such open-market purchases by the Bank of Canada increase the money
supply and lead to inflation. Government pressure on the Bank of Canada to help
out might lead to a more inflationary bias in the economy. An independent Bank
of Canada is better able to resist this pressure from the government.
Another argument for Bank of Canada independence is that control of monetary
policy is too important to leave to politicians, a group that has repeatedly demonstrated
a lack of expertise at making hard decisions on issues of great economic importance,
such as reducing the budget deficit or reforming the banking system. Another way to
state this argument is in terms of the principal agent problem discussed in Chapters 8
9, and 10. Both the Bank of Canada and politicians are agents of the public (the principals), and as we have seen, both politicians and the Bank of Canada have incentives
to act in their own interest rather than in the interest of the public. The argument supporting Bank of Canada independence is that the principal agent problem is worse for
politicians than for the Bank of Canada because politicians have fewer incentives to
act in the public interest.