The Impact of Central Bank Independence on Political Monetary Cycles in Advanced and Developing Nations

Article excerpt

THIS PAPER INVESTIGATES the extent to which monetary policy is manipulated for political purposes during election periods. In the political business cycle model of Nordhaus (1975), politicians attempt to lower the unemployment rate before elections to raise their chances of reelection. Implicit in this idea is, first, that macroeconomic policy is not neutral (at least in the short run) and therefore can alter economic outcomes; second, voters reward politicians for higher growth during election years; third, voters value growth more than other economic objectives such as low inflation; and fourth, politicians are willing and able to manipulate policy to exploit this short-run non-neutrality for their own benefit. Each of these issues has been explored in the literature. (1)

In this paper, we concentrate on the last issue, in particular, the presence of political monetary cycles, where there is a lack of consistent evidence. In most empirical research on this issue, a monetary policy instrument or inflation is regressed on an election cycle variable, whose coefficient is then used to test whether policy is significantly different near elections. Using this approach, Alesina and Roubini (1992), Beck (1987), Golden and Poterba (1980), and Leertouwer and Maier (2001) do not find evidence of political monetary cycles for the United States and Organisation for Economic Co-operation and Development (OECD) countries, in contrast to the findings of Boschen and Weise (2003), Grier (1987), Haynes and Stone (1989), and Abrams and Iossifov (2006).

The conflicting evidence for political monetary cycles may be a result of the literature's concentration on advanced economies. We add to the literature by using a larger sample that also includes developing nations where these cycles are more likely to exist. (2) Central banks in developing countries are less independent from the central government compared to their advanced economy counterparts (Cukierman, Webb, and Neyapti 1992) and therefore are more vulnerable to political pressure. We do not find evidence of political monetary cycles in advanced countries or developing countries with high levels of central bank independence (CBI). We do, however, detect cycles in developing countries with low levels of CBI.

We also investigate the causes of political monetary cycles. There are two primary channels through which political manipulation of monetary policy might operate before or during election years. The first is what we call the Phillips curve channel, in which politicians pressure the central bank to loosen monetary policy to stimulate the economy. The second is the fiscal-financing channel, whereby politicians force the central bank to finance election-related increases in government spending (or tax cuts). The fiscal-financing channel relies on the existence of political budget cycles, in which governments use expansionary fiscal policy to expand the economy and/or increase government handouts and transfers to certain constituencies. (3) These fiscal expansions can in principle be financed through borrowing. In cases where the government's borrowing capacity is limited, however, central banks may be called in to monetize instead. Our results provide some evidence against the fiscal-financing channel. This suggests that pressure on the central bank to stimulate the economy by exploiting the Phillips curve may play an important role in generating political monetary cycles. (4)

The rest of the paper is organized as follows. Section 1 introduces the data and the benchmark regression equation that we use to test for political monetary cycles and the role of CBI. Section 2 presents the results and robustness checks. Section 3 concludes.


In this section, we introduce our benchmark model and data used to test for political monetary cycles and the role of CBI. We consider a regression of a monetary policy indicator, M, on its own lag, an election-cycle variable, EC, and several control variables. …