Academic journal article Economic Inquiry

Central Banking as a Political Principal-Agent Problem

Academic journal article Economic Inquiry

Central Banking as a Political Principal-Agent Problem

Article excerpt


Conventional wisdom holds that during election periods political leaders have incentives to misuse policy instruments to enhance their chances of reelection. Rogoff and Sibert [1988] construct a rational political economy model of monetary policy based on this theme.(1) The results of their model can be interpreted in the following way.(2) Society elects a leader every other period whose competence affects the level of output in the economy and private agents will tend to vote for the incumbent if the level of output is expected to be higher than that which can be provided by an unknown challenger. Voters have imperfect information regarding the politician's true impact on output and exogenous shocks to output and consequently cannot disentangle the effects of one from the other. In an election period, this asymmetry of information gives the incumbent an incentive to expand output through the use of inflationary monetary policy in order to appear more competent than he really is. However, rational voters are aware of this incentive to inflate and adjust their expectations such that, in equilibrium, no gain in output occurs and the economy suffers from excessive inflation.

An implication of the Rogoff-Sibert model is that, unless a society does away with elections as a way to choose policymakers, excessive inflation and a political inflation cycle will be an unavoidable cost of democracy. However, societies can try, and have tried, to avoid these ill-effects by taking the power of money creation away from the elected officials and giving it to an appointed "independent" central banker who will presumably pursue the public good. But can this approach actually work? The problem with this proposal is that the central bankers' well-being in many respects - reappointment, post-central bank employment opportunities, avoidance of public criticism, etc. - often hinges on pleasing their political benefactors, giving the central bankers incentives to act in the interest of elected officials.(3) As a result, the central banker could pursue objectives different from society's and may actually function as a "veil" for the elected policymaker. In the real world, this veil is not complete but partial and, hence, we can characterize the relationship between the monetary authority and society as a principal-agent problem. The advantage of delegating power to an appointed central banker and then erecting appropriate institutions is that the inflation problems may be resolved without abandoning the electoral process.

In this paper we develop a rational political business cycle model that starts from the foundations laid down by Rogoff and Sibert. We depart from their model by having monetary policy delegated to a central banker who is appointed by the elected leaden The concern about reappointment is what motivates the agency problem - the central banker would like to be reappointed and this desire leads her to partially accommodate the wishes of the current administration which, in turn, may not coincide with the desires of the electorate. We then analyze the problem faced by a central banker who is concerned about her own selfinterest as well as social well-being. It is this feature that turns the setting of monetary policy into a political principal-agent problem.

The contributions of our approach to modelling the agency problem of central banking are (1) it explicitly incorporates reappointment concerns into the decision process of the central banker, which heretofore has not been done in the literature, and (2) we explicitly model the source of the agency problem, unlike previous research that simply assumes an agency problem exists.

Our key results are as follows. In equilibrium, the pursuit of her own self-interest leads the central banker to create a socially inefficient inflation bias. While Rogoff and Sibert also obtain this result, our explicit functionalform model allows us to analyze this bias in more detail and tie it directly to the strength of the relationship between the central banker and the current administration. …

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