IN RECENT YEARS MANY countries have adopted or made progress toward adopting legislative proposals removing their central banks from government control, that is, making them independent. Between 1989 and 1991, New Zealand, Chile and Canada enacted legislation that increased the independence of their central banks. The 1992 Treaty on European Union (Maastricht Treaty) requires European Community (EC) members to give their central banks independence as part of establishing the European Monetary Union. As a result, EC countries that do not yet have strongly independent central banks have introduced legislation or announced their commitment to make their central banks more independent.(1) Furthermore, in recent months the governments of Brazil and Mexico have announced their intentions to introduce legislation to create more independent central banks.
In view of these developments, it might seem reasonable to conclude that unambiguous links had been established between economic performance and the degree of central bank independence. Interestingly, however, the two post-World War II star performers among the industrialized economies--Germany and Japan--have different levels of central bank independence. The German Bundesbank is viewed as one of the most independent central banks in the world, whereas the Bank of Japan is seen as more subject to government control. Thus the contrast between the movement to grant central banks more independence and widely different degrees of independence across the major economies raises several questions. Among these are: Why is the idea of an independent central bank popular? Are there economic benefits of having an independent central bank? This paper examines empirical and theoretical studies of central bank independence to address these questions. Empirical researchers have devised measures of independence to focus on the relationship between central bank independence and a country's economic performance. Theoretical studies have modeled the strategic behavior of monetary and fiscal policymakers to be able to compare an economy's performance when policymakers cooperate in setting policies with its performance when they do not cooperate.
The next section of this paper presents a survey and evaluation of empirical studies.-Next, theoretical studies are presented and evaluated. The final section examines the extent to which these studies either explain the current movement toward greater central bank independence or highlight unresolved questions in this debate.
EMPIRICAL STUDIES: CENTRAL BANK INDEPENDENCE AND ECONOMIC PERFORMANCE
Inflation and Central Bank Independence
As a broad generalization, interest in central bank independence was motivated by the belief that, if a central bank was free of direct political pressure, it would achieve lower and more stable inflation.(2) Bade and Parkin (1985) conducted one of the first empirical studies of this link. The authors used data for 12 Organization for Economic Cooperation and Development (OECD) countries in the post-Bretton Woods era and measured the degree of central bank independence according to the extent of government influence over the finances and policies of the central bank.(3) The degree of financial influence on the central bank was determined by the government's ability to set salary levels for members of the governing board of the central bank, to control the central bank's budget and to allocate its profits. The degree of policy influence was determined by the government's ability to appoint the members of the central bank governing board, government representation on this board, and whether the government or the central bank was the final policy authority. Countries were given a rank of one through four in each category, with four being the highest level of central bank independence.
Bade and Parkin concluded that the degree of financial independence of the central bank was not a significant determinant of inflation in the post-Bretton Woods period. Policy independence, however, was seen as an important determinant of inflation because the two countries with the highest degree of policy independence (Germany and Switzerland) had inflation rates significantly below those of all other countries in the sample. They found no significant differences in inflation performance among countries with lower rankings of independence in the post-Bretton Woods era.
Alesina (1988) used the Bade and Parkin (1985) index but added the following four countries: Denmark, New Zealand, Norway and Spain. He found, as hypothesized, that there was generally an inverse relationship between average inflation rates and the level of central bank independence.
Grilli, Masciandaro and Tabellini (1991) created two indexes of central bank independence--one based on economic measures of independence (with a scale ranging from zero to eight), and the other based on political measures of independence (with a scale ranging from zero to seven).(4) The political factors were similar to those identified by Bade and Parkin. The economic factors considered were the ability of the government to determine the conditions under which it can borrow from the central bank and the monetary instruments under the control of the central bank. The data set comprised 18 OECD countries over the period 1950-89.(5) For the period as a whole, Grilli, Masciandaro and Tabellini found that economic independence was negatively related to inflation. Political independence also had a negative correlation with inflation, but the relationship was not statistically significant. Breaking the data into four decade-long subperiods, they found that neither measure of independence had a significant effect on inflation in the first two decades. In the 1970s both measures of independence were significant, whereas in the 1980s only the economic independence measure was significant.
Alesina and Summers (1993) calculated a measure of central bank independence by averaging the indexes created by Bade and Parkin, and Grilli, Masciandaro and Tabellini.(6) The countries included were the same as in Bade and Parkin with the addition of Denmark, New Zealand, Norway and Spain. The sample period was 2955-88.7 As in the previous studies, they found a negative correlation between the level of central hank independence and the rate of inflation. They also found that the more dependent a central bank was, the greater the variability in inflation. This, they argued, was a result of a correlation between the level and variability of inflation.
Cukierman (1992) provided an extensive analysis of central bank independence and its relationship to inflation performance using data for 1950-89. Unlike previous studies, he used not only legal measures of central hank independence, but also practical measures of the level of independence. One such measure was the frequency of turnover of the central bank governors. Another measure of practical independence was based on answers from a questionnaire completed by qualified individuals at the central banks.(8) Cukierman's analysis is the most comprehensive to date, not only because it incorporates information about the actual level of independence a central bank enjoys in practice, but also because it includes a sample of 70 countries.(9) Cukierman concluded that "central bank independence affects the rate of inflation in the expected direction."(10) This result was also found by Cukierman, Webb and Neyapti (1992).(11) Central Bank Independence and the Real Economy
Although most of the empirical work focused on the relationship between central bank independence and the rate of inflation, some studies examined the link between independence and economic output. If an independent central bank can produce lower inflation than a dependent central bank, does this come at the cost of lower output? Conversely, are dependent central banks attempting to exploit a short-run Phillips Curve relationship, accepting higher inflation in order to achieve higher output?
Grilli, Masciandaro and Tabellini (1991) found no systematic effect of central bank independence (using either of their two indicators) on the growth rate of real output. Alesina and Summers (1993) likewise found no correlation between average economic growth or the variability of growth and the level of central bank independence.(12)
De Long and Summers (1992) looked at the relationship between central bank independence and output per worker while trying to eliminate differences between countries that were due solely to …