Academic journal article International Advances in Economic Research

Central Bank Independence and the Cost of Disinflation: Why the Wage Contracts Length Matters?

Academic journal article International Advances in Economic Research

Central Bank Independence and the Cost of Disinflation: Why the Wage Contracts Length Matters?

Article excerpt

Abstract

Recent empirical contributions demonstrate that countries with less independent central banks enjoy lower output losses during disinflationary cycles. To explain these somewhat surprising empirical findings, some authors suggest that independent central banks probably face a flatter short-run Phillips curve. In this paper, we provide both theoretical and empirical arguments to rationalize this intuition. We demonstrate that, since central bank independence reduces the mean inflation rate and its variance, wage setters opt for a lower degree of nominal wage indexation leading to more wage and price inertia and, thus, to a flatter short-run Phillips curve. Consequently, this paper put forward a channel of positive influence of central bank independence on the sacrifice ratio through its impact on nominal wage indexation. Empirical tests, performed using a sample of 19 OECD countries during the 1960-1990 period, show that these theoretical results hold also empirically. (JEL E52, E58)

Introduction

A broad consensus have rallied around the idea that central bank independence eases the attainment of price stability at little or no real economic cost. The main factor motivating these central banks reform has been the belief that independence of central banks, with a clear mandate to maintain price stability, may be an institutional mechanism intended to increase the credibility of policymakers commitment to stable prices and to reduce the short-run output losses associated with lowering inflation through the change of private sector expectations [Rogoff, 1985].

Several empirical studies have found a negative correlation between inflation and central bank independence and no systematic relationship between central bank independence and real economic performances [Grilli et al., 1991; Cukierman, 1992; Alesina and Summers, 1993]. The credibility bonus of central bank independence is presumed to be the source of these results. However, an interesting body of recent empirical literature on the real cost of disinflation [including Debelle and Fischer, 1994; Gartner, 1995; Fischer, 1996; Jordan, 1997; and Posen, 1998] conclude that the output costs of disinflation are higher, not lower, in countries with independent central banks emphasizing that there is no "credibility bonus." (1) One of the most usual way to rationalize these somewhat surprising empirical findings is to assume that a high degree of central bank independence shifts the output inflation trade-off (or the Phillips curve) inwards while, at the same time, flattering it [Walsh, 1995]. The purpose of this paper is to add to the literature by providing a theoretical framework allowing for a formal demonstration of this explanation. In this context, if the degree of nominal wage indexation (or the wage contract length) is endogenous, the optimal monetary policy and the optimal degree of wage inertia are determined jointly through the strategic interactions between monetary authorities and private sector. In this environment, with the central bank more firmly committed to price stability, the outcome is that private agents opt for a lower degree of nominal wage indexation or longer wage contracts leading to more wage and price inertia [Mourmouras, 1997; Diana and Sidiropoulos, 2005].

The starting point of our analysis is the well-known time inconsistency problem associated with discretionary monetary policy, first analyzed by Kydland and Prescott [1977] and Barro and Gordon [1983]. The basic idea is that wage-setters recognize the policymaker's incentive to exploit the short-run Phillips curve. In equilibrium, unemployment is unaffected by monetary policy, but inflation is positive. Rogoff [1985] suggested that appointing a conservative central banker will reduce the inflationary bias at the expense of higher employment variability. In this paper, we extend the game-theoretic model of monetary policy developed by Rogoff [1985] by assuming that wage-setters choose optimally the degree of nominal wage indexation or contract length. …

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