Academic journal article Journal of Money, Credit & Banking

Central Bank Independence, Inflation, and Growth in Transition Economies

Academic journal article Journal of Money, Credit & Banking

Central Bank Independence, Inflation, and Growth in Transition Economies

Article excerpt

This paper documents two empirical relationships that have emerged as the former communist countries have taken steps to transform their economies. First, data from a sample of twelve transitions economies suggest that increased central bank independence (CBI) is correlated with lower inflation rates. This CBI-inflation correlation is not well explained by initial economic conditions and persists after controlling for fiscal performance and the overall quality of economic reforms. Second, across a larger set of twenty-five transition economies, there is a strong and robust negative relationship between inflation and subsequent real GDP growth. Inflation's adverse effect on investment appears to be one significant channel through which the relationship between inflation and growth arises.

More than five years after the implementation of the initial economic reform programs in Eastern Europe and the former Soviet Union, it is now possible to begin evaluating the lessons that have been learned during the first stages of the transition process. In this paper, therefore, we use data from a panel of transition economies to examine two important relationships: (i) the effect of central bank structure on inflation, and (ii) the impact of inflation on economic growth. More specifically, in section I of this paper we develop indices of central bank independence (CBI) for twelve transition economies; these countries are used in our analysis because Hinton-Braaten (1994) and Lewarne (1995) have extracted the relevant information from central bank charters, national constitutions, and legislation. The main finding in this section is the existence of a negative correlation between the degree of CBI and inflation; that is, countries with more independent central banks have had lower inflation than their counterparts. This relationship is not well explained by initial economic conditions in each country and persists after controlling for other measures of economic policy, such as fiscal performance and the overall quality of economic reforms. In section 2 of the paper, we present evidence for a broader set of twenty-five transition economies that those countries with lower inflation achieved higher real GDP growth in subsequent years, even after accounting for the effects of fiscal deficits, the extent of economic liberalization, and the possibility that real GDP growth may be mismeasured. Inflation in these countries has had an adverse effect on investment, which apparently is one channel through which the relationship between inflation and growth has arisen. These results are consistent with recent work by Barro (1995) and Bruno and Easterly (1995) suggesting that high inflation adversely affects economic growth.

1. CENTRAL BANK INDEPENDENCE AND INFLATION IN TRANSITION ECONOMIES

1.1 Literature Review: The Components of CBI

While the theoretical literature on this topic is vast, we restrict our attention to three studies that are particularly useful in thinking about the individual components that make up an index of central bank independence.

Grilli, Masciandaro, and Tabellini (GMT) (1991), among others, have divided central bank independence into two components: "political independence" and economic independence." They argue that a central bank's political independence is determined by a number of factors, including the procedures for appointing the central bank's chairman and board members, the term of office of central bank officials (a longer term suggesting greater independence), and whether the central bank's responsibility to achieve price stability is explicitly stated in the central bank charter. More broadly, political independence reflects the degree to which the central bank is allowed to pursue its main objective, presumably price stability, without interference from the political authorities. GMT suggest that economic independence hinges on whether the central bank has power to control the quantity of credit it lends to the government, and the central bank's freedom to determine the interest rate that is charged on that credit. …

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