Lecture 9

Central Bank Independence and Conservative Central Banking

• This lecture extends the analysis of reputation and credibility to the theory of central bank independence

Credibility building strategies

• Credibility building measures include:

• 1) Joining and exchange rate mechanism- ERM?

• 2) Consistent fiscal and monetary policy - stability pact?

• 3) Independent Central Bank

Independent CB

• This lecture will examine the third of these strategies

• Staring point is a Rational Expectations Phillips curve where x is the deviation of output from equilibrium.

• x = ( - e) + • where is inflation, e is the expected rate of

inflation and is a random shock

Society’s Iso-Loss function

2221 xxbEL

x0

C0

C1

C2

x-

Time-consistent policy is given by agents optimising

xb

xbEL

xbEL

e

e

e

02221

2221

But the CB/government optimises

bx

b

bxb

xbplug

xbL

xbL

e

e

e

1

11

02221

2221

The time-inconsistency problem

• The last 2 equations highlight the time-inconsistency problem

• the term bx- implies that the average

inflation rate is above zero

• The first best policy would be to eliminate the inflation bias without eliminating the degree of output stabilisation

But this is not credible

22

2

1

1

1

1

b

b

x

The ‘Inflation Nutter’ Deflationary bias

x

A

B

CC1

C2

C3

>0

=0

<0

C’B’A’

Optimal set of preferences for a CB

1

1

1

2221

x

x

x

xxELe

B

Substitute CB preference result into societies loss

function

22

21

1

1

1xbxL

Optimising with respect to

0

1 3

22

bxL

Summary

• Rogoff argues that < b - we need a conservative CB but not too conservative

• The model can be criticised - why should society prefer x- > 0 when x* = 0?

• Has to be argued in terms of distribution - political economy terms

• Minford critique - society gets the CBs they deserve?

Evidence - Inflation?Chart 1

Central Bank Independence and average inflation rate 1971-95

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Ranking of Independence

perc

en

t

Germany

Switzerland

USA Japan

Netherlands

Canada

Belgium

DenmarkFrance

UK

Italy

Growth VariabilityChart 3

Relative variability of growth 1971-95 and CB rank of Independence

0

20

40

60

80

100

120

140

160

180

0 2 4 6 8 10 12

Rank

per

cen

t

German

Switzerland

USA

Japan

NetherlandsCanada

BelgiumDenmark

France

UK

Italy