Checks and balances, private information, and the credibility of monetary commitments

Abstract

We argue that the effectiveness of central bank independence and of exchange rate pegs in solving credibility problems is contingent on two factors: political institutions and information asymmetries. However, the impact of these two factors differs. We argue that the presence of one institution, multiple political veto players, should be crucial for the effectiveness of central bank independence, but should have no impact on the efficacy of exchange rate pegs. In contrast, exchange rate pegs should have a greater anti-inflationary impact when it is difficult for the public to distinguish between inflation generated by policy choice and inflation resulting from exogenous shocks to the economy. Such information asymmetries between the public and the government, however, do not increase the efficacy of central bank independence. Empirical tests using newly developed data on political institutions provide strong support for these hypotheses