The Effects of Central Bank Independence

1. The Effects of Central Bank Independence Daniel West November 6, 2007

2. Based primarily on: • Alesina, A. and Summers, L., " Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, May 1993, 151-162 • Cukierman, A., Central Bank Strategy, Credibility, and Independence, MIT Press, 1992, Ch. 20.

3. Topics to Cover: • Overview • Alesina/Summers: • How do we measure “independence”? • Various plots of data • Conclusions: • Inflation negatively correlated with independence • Real variables unaffected

4. Topics to Cover: • Cukierman • Measuring independence • Differences in studies • Developed vs. undeveloped countries • Two-way causality • Conclusion: Not as basic as Alesina/Summers

5. Overview • “Delegating monetary policy to an agent whose preferences are more inflation averse than are society’s preferences serves as a commitment device that permits sustaining a lower rate of inflation than would otherwise be possible.” • Monetary policymakers must be insulated from popular opinion, which will try to recall them when they are tight on inflation

6. Overview • There is also a theoretical case for central bank independence affecting real variables • Positive effects proposed: economic stability, reducing risk premia on interest rates, avoiding political manipulation of the economy, avoiding all the detrimental economic effects of inflation • Negative effects proposed: lost benefits of active monetary policy in reducing unemployment and increasing output (independent central bankers will prioritize inflation too strongly, causing an inferior social outcome)

7. Overview These studies attempt to test the aforementioned hypotheses with actual data, in order to determine the empirical consequence of central bank independence.

8. Methodology: Alesina/Summers • How does one quantify “independence”? • Two different scales: Bade/Parkin (1982) amended by Alesina (1988), and Grilli, Masciandaro, and Tabellini (1991) • The study uses the average of the two scales

9. Bade/Parkin/Alesina Scale • Scores of 1-4 based on “political independence” • Contributing Factors: • Institutional relationship between central bank and executive • Procedure to nominate and dismiss bank head • Role of government officials on bank board • Frequency of contacts between executive and bank

10. Grilli/Masciandaro/Tabellini Scale • 1-13 scale based on both “political” and “economic” independence • Contributing factors: • Political: • Length of appointments, gov’t representatives on the board of the bank, gov’t approval required to make monetary policy, “price stability” objective • Economic: • Freedom of central bank to make monetary policy without constraints such as financing deficits

12. Figure 1a: Independence vs. Inflation Variability

13. Figure 1b: Independence vs. Inflation Variability

14. Independence vs. Inflation • As theory would suggest, there is a very strong negative correlation between central bank independence and inflation • The strong correlation between the level and variability of inflation is demonstrated in Figure 1b, where we see a strong negative correlation between central bank independence and inflation variability

15. Figure 2a: Independence vs. Average Real GNP Growth

16. Figure 2b: Independence vs. Variance in Real GNP Growth

17. Figure 3a: Independence vs. Avg. Per Capita GNP Growth

18. Figure 3b: Independence vs. Variance Per Capita GNP Growth

19. Independence as a Determinant of Growth? • It appears from these data that there is no relationship between central bank independence and either the level or the variability of economic growth, either at the national or per capita level.

20. Figure 4a: Independence vs. Average Unemployment

21. Figure 4b: Independence vs. Variance Unemployment

22. Independence as a Determinant of Unemployment? • These data seem to show a slight, if any, correlation between either the level or variance of unemployment and the independence of the central bank of the nation. • It would be helpful to run a multiple regression to see whether the slight downward slope is due to a correlation between inflation and unemployment.

23. Figure 5a: Independence vs. Average Real Interest Rate

24. Figure 5b: Independence vs. Variance Real Interest Rate

25. Independence as a Determinant of Interest Rates? • The data show no long term correlation between central bank independence and the level of the interest rate (though banks can manipulate rates in the short term with monetary policy) • The variance of the real interest rate does have a clear negative correlation with independence—which makes sense, since inflation is much less varied as well

26. Conclusions: Alesina/Summers • While the level of independence of the central bank of a nation has a large impact on inflation, it has no effect on the other real variables covered • This data thus supports the theory of monetary neutrality and the classical dichotomy • Anti-inflationary benefits of central bank independence are very likely to outweigh any output costs • Rule-based monetary policy isn’t necessary to keep inflation low; only a politically insulated central bank

27. Methodology: Cukierman • In measuring independence, Cukierman makes a distinction between the legal and actual priorities of the central bank • He uses the variable “obj” which measures the legal obligation (as written in the statutes) to maintain price stability • He uses the variable “qpps” which measures the actual priority the banks place on price stability, as reported in a questionnaire

28. Table 20.1

29. Table 20.1 • Variables regressed against “d” (depreciation in the real value of money) • tor: the average number of changes in CB governors per annum within each country • The addition of tor from regression 1 to regression 2 causes the adjusted R squared to rise from .11 to .28 • This suggests that this variable includes factors of independence above and beyond the legal variables

30. Table 20.1 • Regressions 4 and 5 split up developed and non-developed countries • Legal variables are significant in developed countries but insignificant in undeveloped countries • Turnover variable insignificant and negative in developed countries, but significant and positive in undeveloped countries • This suggests that turnover is a better measure of actual independence in developing than in developed countries • Consistent with torl and torh observations: turnover negatively associated with independence only in high turnover ranges

31. Table 20.2

32. Table 20.2 • The variable “LVAW” is presented as an aggregate of all legal independence variables • The variable “comp” is an index of the degree of compliance to the law in turnover of CB governors • Table 20.2 regresses these variables against “d” for all countries, developed countries, and “less developed” countries

33. d vs. LVAW and comp, for developed and less developed countries

34. Conclusions from Table 20.2 • Legal independence can be used as a proxy for actual independence in developed countries • In developing countries, it is better to use the difference between the legally mandated and actual terms of office of CB governors • This indicates rule of law (institutions) is much stronger in developed than in developing nations

35. Two-Way Causality • There is possibly two-way causality between actual CB independence and inflation • Low independence causes high inflation, as shown • High inflation, however, may cause low independence, as the bank loses credibility and faces more pressure and higher turnover • On the other hand, high inflation may lead to reform/commitment (see Germany) • Cukierman concludes that low independence and high inflation do, at least partially, reinforce each other

36. Conclusions: Cukierman • Central bank independence does cause lower inflation, but other factors must be considered • Discrepancies between actual and legal independence much higher in developing countries • As a result, policies which work well in developed countries may perform poorly in less developed countries • The turnover rate of governors can be used as a good proxy of actual independence in less developed countries

37. Thank You. http://www.smh.com.au/ffximage/2005/10/25/Bernanke_wideweb__430x278.jpg