Academic journal article Brookings Papers on Economic Activity

Central Bank Independence and Inflation

Academic journal article Brookings Papers on Economic Activity

Central Bank Independence and Inflation

Article excerpt

One of the most studied types of policy reform is the introduction of CBI. Theoretical work in the early 1980s argued that when unanticipated changes in monetary policy can reduce the rate of unemployment, the government will be unable to commit to low inflation, and consequently inflation will be suboptimally high. (36) Kenneth Rogoff's proposed solution to this problem, namely, to delegate monetary policy to a conservative central banker, established a theoretical rationale for creating independent central banks. (37)

A large number of empirical studies over the past fifteen years have examined the impact of CBI on inflation, economic growth, and a variety of other variables. (38) Some early studies used a measure of de jure CBI (we describe the construction of the various measures of CBI below) and exploited cross-sectional variation within OECD countries. (39) Alberto Alesina and Lawrence Summers report a near perfect negative correlation between inflation and de jure CBI. (40)

This de jure index of CBI was further developed by Alex Cukierman, Steven Webb, and Bilin Neyapti and extended to seventy-two independent countries over the period 1950-89. (41) Using their index in pooled time-series and cross-sectional regressions, that study and another by Cukierman show that the negative correlation between de jure CBI and inflation does not hold for a cross section of developing countries, although they confirm the earlier negative correlation for developed countries. (42) They also show that their index of de facto CBI (based on the turnover of central bank governors) is negatively correlated with inflation in developing countries, but not significantly correlated with inflation in developed countries. (43)

Nevertheless, other studies find very different results. Using updated data, Christopher Crowe and Ellen Meade do not find the same correlations. (44) Marta Campillo and Jeffrey Miron argue, as does Thomas Oatley, that the correlation between de jure CBI and inflation is not robust to the inclusion of various covariates, such as measures of openness or the government deficit. (45) Oatley, Gabriel Mangano, James Forder, and King Banaian, Richard Burdekin, and Thomas Willett also document that the results depend on the subjectively coded details of CBI measures and are not generally robust. (46)

Philip Keefer and David Stasavage, (47) in work related to this paper, argue that CBI will be effective only if it cannot be reversed, and that this will happen only if there are political checks and balances. In their empirical work they interact a measure of checks and balances from Thorsten Beck and coauthors with CBI and find that introducing CBI increases inflation unless checks and balances are sufficiently strong. (48) Their work, like much of the rest of this literature, exploits only cross-sectional variation. This strategy makes omitted-variable bias potentially quite severe, since the countries that have introduced CBI typically have different macroeconomic equilibria than the rest.

In contrast to almost all of this literature, we focus on within-country variation. Although not a panacea against omitted-variable bias, fixed-effects panel data regressions provide more convincing and more relevant conditional correlations, focusing on whether inflation declines following the introduction of CBI. Using such regressions, we will show that the introduction of CBI appears to be associated with declines in inflation in countries with intermediate political constraints. The benefits of CBI in more developed economies appear to be more limited. (49)

The Motivating Theory

In this section we use a simple model to clarify our approach to the political economy of reform, and we derive hypotheses concerning the circumstances under which CBI should have a significant impact on inflation. Our purpose is not to contribute to the theoretical literature on the political economy of reform, but rather to highlight why specific institutional reforms might have different effects depending on the constraints facing politicians. …

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