Political and Economic Determinants of Interest Rate Behavior: Are Central Banks Different?

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I. INTRODUCTION

Do politicians manipulate the instruments of macroeconomic policy to improve their electoral prospects or in response to the preferences of their own party? These questions are addressed, but not yet resolved, by the literature on political business cycles.(1)

To generate a political business cycle, politicians must control the instruments of macroeconomic policy. Monetary policy plays an important role in the determination of inflation, output and employment, the objects of concern to politicians and voters. Yet, politicians do not directly control the instruments of monetary policy in industrialized countries. Instead, these instruments are controlled by the central banks, which vary widely across countries in their degree of statutory independence. We wish to examine empirically whether monetary policy is influenced by the timing of elections or a change in the party in power after controlling for unexpected changes in economic fundamentals. Our paper assesses, therefore, one aspect of independence, namely whether a central bank makes monetary policy decisions without measurable political influence.(2)

In this study we attempt to look at what central banks actually do as opposed to what they are legislated to do, to distinguish between the form and substance in discussions of central bank independence as in Mayer [1976].(3) Our paper enlarges and improves on Cowart [1978] and Woolley [1983], both of whom studied the role of political factors in monetary policy for a sample of industrialized countries. Our methodology is to compare the responsiveness of interest rate changes to economic and political factors in seventeen countries. As we discuss below, there are differences in opinion about whether an interest rate variable or a monetary aggregate is a better representation of monetary policy actions.

We compare the results of qualitative measures of differences in central bank design - e.g., rankings of banks in order of independence as determined by legislative criteria - with the results of a quantitative comparison of differences in central bank behavior. This exercise should help identify the important qualitative features in the reform of existing central banks or in the design of new central banks.(4)

In our empirical work the relevant relationships are estimated with a recursive vector autoregression technique to control for temporal instability in the economy between 1960 and 1990 and the endogeneity of the variables in question. This methodological innovation has important consequences for the understanding of reaction functions and, more generally, for measuring the impact of macroeconomic shocks on monetary policy. We also stress results for separate subsamples of fixed and flexible exchange rates as well as for the full sample. Our methodology measures the influence of politics on monetary policy relative to the choices and information actually available to the central bank when the monetary policy decision was made.

Our study does not measure the influence of politics on the instruments of fiscal policy as in Alesina et al. [1991]. Our study also does not measure the direct influence of fiscal variables on the instruments of monetary policy, although there is some evidence on this issue in, for example, Parkin [1986] and Burdekin and Wohar [1990]. Burdekin and Wohar estimate the relationships between deficits, money base growth and inflation for a sample of countries and time period comparable to ours. All these studies find some evidence that central banks do accommodate fiscal policy by financing deficits via money growth, especially since the end of Bretton Woods. We return to the issue of fiscal policy in considering the interpretation of our results but stress that the effects of fiscal policy are partly captured in our specifications because we measure monetary policy relative to the state of the economy.(5)

A brief review of the literature which measures statutory central bank independence is given in section II. …