The problem of monetary policy delegation is formulated as a two-stage non-cooperative game between the government and the central bank. Second, in my model the degree of independence is expressly granted by the government to the central bank. In the first stage of the game, the government appoints a central banker and chooses how much independence to grant the central bank.
The economic model is introduced in Chapter 2 and the objectives of the government and the central bank are specified and discussed in Chapter 3. The policy game between the government and the central bank is described and resolved in Chapter 4.
Government and Central Bank Objectives
The extent of a central bank's freedom to set its own policy objectives depends on the degree of independence the central bank enjoys. There may be provisions that allow the government to borrow from the central bank at below-market interest rates. These are examples of provisions that reduce the economic independence of the central bank, that is, the central bank's ability to pursue political goals without having to consider the goals of the government.
Legal provisions that prevent a government from populating the central bank with its own appointees are, in Grilli, Masciandaro, and Tabellini's (1991) terminology, a source of political independence. Other factors that contribute to political independence are, for example, the central bank's freedom to set its inflation target independently and to implement monetary policy without first. A central bank's economic independence is incomplete if the government has the ability to impose some of its own goals on the central bank.
The parameter δ measures the degree of economic independence that the government grants to the central bank. As specified, (8) includes two of the factors identified above as contributing to a central bank's political independence. When a central bank has full political independence, neither the central bank's inflation target, ˆπ, nor its relative weight on output, λcb, can be influenced by the government.
For the purposes of this study, I will assume that the government and the central bank share the same inflation target and that the government can exercise full control over λcb.
The Policy Game
Stage 2
Optimal Conservatism and Economic Independence
According to (25), the degree of economic independence that the government should transfer to its central bank depends on the structural parameters of the economy (α, β, γ, τ and b), the behavioral parameters of the government (λg1, λg2 and θ ) and varies according to the level of conservatism of the central bank (λcb). 11Adding (1−δ)λcb2 [(b−θ)yt−τtr]2 to the central bank loss function (8) has no effect on the expected losses (26) and (27) as long as all λcb,δ and λcb2 are optimally chosen by the government in the first phase of the game. Given that δ= 1 is not a solution to the political game, it must be held that a certain degree of central bank independence is necessary if government losses are to be minimized.
When φ >0 andλcb < λg1, a decrease in central bank economic independence leads to higher money growth, higher transfer payments, and higher inflation. The effect of a decrease in central bank economic independence can be offset by appointing more conservative central banks (that is, by reducing λcb). According to increasing central bank conservatism (ie, decreasing λcb), the growth rate of money supply, transfer payments and inflation is reduced when φ is positive.
Equation (25) shows that the optimal degree of central bank independence is partly determined by the structure of the economy and the objectives of the government. The intuition behind the relationship between central bank independence and government preference parameter λg1 is simple. It is clear from (17) that for a given λcb, inflation and central bank independence are negatively correlated.
According to (25), appropriate combinations of partial independence and central bank conservatism also lead to the optimal outcome.
Inflation and Central Bank Independence
Posen's empirical results indicate that the level of financial sector resistance to inflation is a fundamental determinant of inflation performance. Neither Posen nor Campillo and Miron find any evidence of a significant causal relationship between the degree of central bank independence and the average inflation rate.15. Moreover, when inflation is reduced based on income inequality and central bank independence, the coefficient for centrality becomes.
This analysis indicates that inflation performance, optimal central bank conservatism and the optimal degree of central bank independence are jointly determined by economic structure and the preferences of the policy authority. The relationship between inflation and the redistribution parameters, λg2 and θ, is also consistent with the hypothesis that inflation and central bank independence are both endogenous. Dolmas, Huffman and Wynne find that the positive relationship between inflation and inequality holds for democracies and non-democracies. 42).
Equations (37) and (41) show that governments that care more about redistribution prefer lower inflation rates and therefore give their central banks more independence. Similarly, (38) and (42) show that more egalitarian governments give their central banks greater independence in order to lower the inflation tax on the poor. However, I now show that when the degree of central bank conservatism is suboptimally low (that is, when λcb is too high), there is a positive correlation between central bank independence and inflation.
16 In special circumstances, it is possible for the correlation between central bank independence and average inflation to be positive in optimizing countries.
Conclusion
Equation (45) predicts that a systematic tendency among a group of countries to appoint suboptimal liberal central bankers will be reflected in cross-sectional data as a positive correlation between central bank independence and inflation. Thus, by making explicit the relationship between central bank independence and inflation performance, the model used here provides a theoretical explanation for the empirical finding of Cukierman, Webb, and Neyapti (1992) that central bank independence and average inflation are negatively correlated at high inflation rates. income countries, but positively correlated in middle and low-income countries. The framework I use provides a theoretical basis for interpreting the results obtained from empirical research on the relationship between inflation and central bank independence.
The theoretical results show that the course of inflation is invariant to changes in the optimal combination of conservatism and central bank independence. For optimizing countries, the negative correlation between central bank independence and inflation arises from a systematic relationship between the government's preferred inflation rate and the degree of independence that is consistent with this inflation rate. I also show that suboptimal combinations of conservatism and central bank independence result in a positive correlation between inflation and central bank independence.
Specifically, when the government-appointed central banker is very liberal, inflation and central bank independence are positively related. There are two main differences between the model used here and models that have been used in previous studies of central bank design. I also consider allowing the central bank to have more autonomy, either by allowing the central bank's inflation target to differ from that of the government or by limiting the government's ability to influence the degree of central bank conservatism.
The qualitative features of the main results are retained in each of these alternative specifications of the model.
Dixit, Avinash and Luisa Lambertini, “The Symbiosis of Monetary and Fiscal Policy in Monetary Union,” unpublished manuscript, March 2000. Dixit, Avinash and Luisa Lambertini, “Monetary-Fiscal Policy Interactions and the Commitment to Discretion in Monetary Union,” European Economic Review. Jr., “Partially Independent Central Banks, Politically Responsive Governments, and Inflation,” American Journal of Political Science.
Herrendorf, Berthold, and Ben Lockwood, “Rogoff's 'Conservative' Central Banker Restored,” Journal of Money, Credit, and Banking 29, November. Lockwood, Ben, “State-Contingent Inflation Contracts and Unemployment Persistence,” Journal of Money, Credit, and Banking 29, August. Anton, “Optimal Inflation Contracts and Inflation Targeting under Uncertainty: Why We May Need Conservative Central Bankers,” University of Glasgow Discussion Paper no.
Posen, Adam S., “Declarations are not Enough: Financial Sector Sources of Central Bank Independence,” in Ben S. Rogoff, Kenneth, “The Optimal Degree of Commitment to an Intermediate Monetary Target,” Quarterly Journal of Economics 100, November . Schaling, Eric, Marco Hoebrichts, and Sylvester Eijnger, “Incentive Contracts for Central Bankers Under Uncertainty: The Walsh-Svensson Inequality Revisited,” CentER for Economic Research Discussion Paper No.
Svensson, Lars E.O., "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," American Economic Review 87, marts.
Appendix
Model Variations
A comparison of (A.3) and (A.4) with (25) and (27), respectively, shows that when there is a political cost of imposing new taxes, the optimal degree of central bank independence and the minimal loss are . the government can expect to achieve both increase. Bonds can be sold to either the central bank or the private sector, but I assume that only the rich use their after-tax savings to buy government bonds. In the main text, I assume that the government and the central bank have the same inflation target.
This variation in the model is implemented by replacing the central bank's objective function (8) with. 2 [(b−θ)yt−τtr]2 (A.9) where ˆπcbis the central bank's inflation target, which may differ from the government's inflation target ˆπ. When the central bank and the government have different inflation targets, the optimal degree of central bank independence (δ) and the minimum loss the government can expect to achieve (ELgt) are given.
It appears from (A.10) that the lower the central bank's inflation target relative to that of the government, the lower the optimal degree of central bank independence for any given degree of central bank conservatism. However, as long as the government knows what the central bank's inflation target is and adjusts δ and/or λcb accordingly, the minimum losses that the government can expect to achieve will be completely unaffected. In this section, I relax the assumption that the government has full control over the degree of central bank conservatism.
Therefore, I replace λcbin (8) with the expression λcb = (1−p)ˆλcb + pλcbg (A.12) where 0≤p≤1 represents the proportion of central bank officials that the government has.
