Jane Bogoev National Bank of the Republic of Macedonia Goran Petrevski

1. What matters more in reducing inflation in ex-communist economies - the degree of central bank independence or financial opposition to inflation? Evidence from dynamic panel data models Published as: Jane Bogoev, Goran Petrevski, and Bruno S. Sergi, "Reducing Inflation in Ex-Communist Economies Independent Central Banks Versus Financial Sector Development",Problems of Post-Communism, Volume 59, Number 4 / July-August 2012, pp. 38 – 55. Jane Bogoev National Bank of the Republic of Macedonia Goran Petrevski Faculty of Economics, Skopje, University “Ss. Cyril and Methodius” and NBRM Bruno Sergi University of Messina

2. Aims of the research: • To examine the impact of the level of legal CBI on inflation in 28 transition economies during 1990-2010; • To control for the reverse causality between CBI and inflation by employing more efficient estimator; • To control for various other exogenous and endogenous economic and institutional factors that may also influence inflation; • To apply a dynamic model due to the persistence in inflation.

3. Motivation of the research: • Updating the time-span for the transition economies in order to assess the role of legal CBI on inflation, including the recent period of stable macroeconomic environment; • Are the results of the previous empirical studies for transition economies sensitive to including additional control variables and to omitted dynamics (model misspecification); • The need for a proper control for reverse causality between CBI and inflation;

4. Theoretical background (1): • The theoretical basis for CBI originates from the industrialised economies back in 1980s and is related to the “time inconsistency” and “inflationary bias” of monetary policy; • A possible solution as suggested in the literature is the “delegation” approach; • One strand of the literature suggests appointing a conservative central banker, Rogoff (1985) or imposing incentive contracts for the central bankers, Walsh (1995); • Another strand of literature is related to the “Political Business Cycle” models (PBS) where the policy makers deviate from the medium voter’s preferences such as “office motivated politicians” (Nordhaus, 1975) and “partisan politicians” (Hibbs, 1977, Alesina, 1988, Alesina and Stella, 2010)

5. Theoretical background (2): • Critical appraisal of the delegation approach: • The conservative central banker may be much more concerned with stabilising inflation deviations than economic fluctuations, which in economic downturns may make the society worse off; • The weaknesses of the PBS models are related to the assumptions of short-memory voters; • Wage contracts are fixed, non re-negotiable and are signed before the elections; • PBS is based on two-party approach, excluding the possibility of having a third political stream that may represent the “medium voter’s” preferences; • Critical appraisal of the “time inconsistency” approach: • The “time inconsistency” literature neglects the reverse causality issue: the aversion of inflation of the society has made the CBs more independent, not the higher inflation and “time inconsistency” by itself; • CBI has succeeded and not preceded the disinflation in early 1980s (disinflation was achieved without any additional institutional arrangements).

6. Theoretical background (3): • A different strand of the literature indicates that greater CBI is a result of the preferences of various interest groups that have high aversion to inflation such as, the banking and the financial sector; • According to Posen (1995 and 1998), banking and financial sector interest groups with high aversion to inflation lobby for greater CBI. When CBs are more independent, monetary policy makers can be more easily influenced by the financial sector lobby in terms of making monetary policy decisions and regulatory requirements; • Accordingly, greater financial sector development indicates greater aversion to inflation (greater financial opposition to inflation) and, hence, greater possibility for influencing the decisions of the CBs, thus, leading to lower inflation.

7. Survey of the empirical studies: • The pioneering empirical analyses for developed economies are based on simple (bivariate) regression approach and have reached a straightforward conclusion for significant and negative association between inflation and CBI (Bade and Parkin, 1988; Grilli et al., 1991 and Cukierman et al., 1992); • Recently, the empirical studies have examined the link between CBI and inflation in a multivariate setting by including various control variables. • The empirical results are mixed: some of them have confirmed the significant and negative association between CBI and inflation (Eijffinger and Stadhouders, 2003; Brumm, 2000, Bleaney, 1996 and Cottarelli et al., 1998), while others have not (Campillo and Miron,1996; Oatley, 1999; Destefanis and Rizza, 2007, and Klomp and de Haan, 2009); • The empirical studies for transition economies have found a significant and negative relationship between CBI and inflation (Loungani and Sheets, 1997; Maliszewski, 2000; Cukierman et al., 2002 and Eijffinger and Stadhouders, 2003).

8. General weakness of the existing empiricalstudies: • They are based on static panel data models and omit dynamics, which may provide biased and misleading results for two reasons: • First, inflation has a persistence (inertia), see BlanchardandKatz(1999), Calvoetal. (2007), Cooreyetal. (1998), RudebuschandSvensson(1999),Sargent(1986) andSiklos(1999). Therefore, static models of inflation may be misspecified; • Second, even when lagged inflation is not the main variable of interest, adding dynamics is a major change in the interpretation of the equation (Greene, 2003). • All of the studies do not properly deal with the endogeneity issue of CBI measure (reverse causality) that again may provide inconsistent and biased estimates.

9. Empirical approach for assessing CBI in transition economies: • The sample includes all 28 transition economies during1990-2010; • We use two measures for quantifying the level of legal CBI: a) Cukierman et al., 1992 index (CUK) and b) Grilli et al. (1991) index (GMT); • We include financial sector development variable as a proxy for financial opposition to inflation composed as an average of two EBRD indices: 1) banking sector ref. and int. rate lib. and 2) development of securities markets and non-bank fin. inst.; • We also include the cumulative liberalisation index as an instrumental variable, which controls for the initial period of transition and external and internal liberalisation of the economies (de Melo et al., 1996); • We use a dynamic panel data model allowing for inflation persistence; • We employ the “system” GMM estimator that is designed for panels where N>T and controls for the endogeneity of the regressors; • We include various institutional and economic control variables specific for the transition economies.

10. The empirical model: Yit = β0 + δYit-k + β1Zit-1 + β2FOIit-1 + X'it β3 + w'it β4 + uit uit = vi + eit Where: • Y is the dependent variable (the inflation rate); • Yit-kis the lagged dependent variable, where k indicates the number of lags; • Zit-1 is the one period lagged measure of the legal CBI (CBI index); • FOI is the financial sector development variable (proxy for financial opposition to inflation); • X'itisavectorofexogenousvariables (foreign inflation and trade openness); • w'itis a vectorofendogenous and predetermined variables (output gap, budget balance,and IMF and fixed exchange rate dummy variables); • β0,δ, β1, β2, β3 and β4 are the parameters to be estimated: the constant, the lagged inflation, the parameter before the CBI and the rest of the control variables, respectively; • uit is the compound errortermmadeupoftwocomponents: theunobserved, time invariant country-specificeffect (vi) and the i.i.d error term (eit); • i and t are the country and time subscripts, respectively.

11. Inflation, CBI and FOI some stylized facts:

12. Results of the parsimonious model (1):

13. Results of the parsimonious model excluding the exchange rate variable (2):

14. Conclusions: • The level of CBI has not been the most important disinflation factor. The role of CBI as a disinflation device in transition economies might have been overstated; • The disinflation process have been predominantly affected by other macroeconomic and institutional factors related to the overall process of economic transformation; • Financial sector development is one of the most signifcant factors behind disinflation, which is in line with Posen (1995, 1998) and implies that disinflation process reflects the inflation aversion of the finacial sector and the society; • Granting a higher level of legal independence to CBs in transition economies may not be a sufficient condition for lowering inflation; • An important issue for further investigation is the actual behaviour of central bankers that is beyond the scope of this paper.

15. Thank you for your attention!

16. Appendix 1: subjectivity bias