Central bank independence: Theory and evidence (Revised version)

Game Theory;Central Banks

The ultimate determinants of central bank independence

Using a graphical method, a new way of determining the optimal degree of central bank conservativeness is developed in this paper. Unlike Lohmann (1992) and Rogoff (1985), we are able to express the upper and lower bounds of the interval containing the optimal degree of conservativeness in terms of the structural parameters of the model. Next, we show that optimal central bank independence is higher, the higher the natural rate of unemployment, the greater the benefits of unanticipated inflation, the less inflation-averse society, and the smaller the variance of productivity shocks. These propositions are tested for nineteen industrial countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, New Zealand, the Netherlands, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States) for the post-Bretton-Woods period (1960-1993). In testing the model we employ a latent variables method (LISREL) in order to distinguish between actual and optimal monetary regimes.Central Banks;Monetary Policy;monetary economics

Central bank independence: Searching for the philosophers' stone (Revised version)

Central Banks;Monetary Policy

Optimal commitment in an open economy: Credibility vs. flexibility

Using a graphical method, a new way of determining the optimal degree of central bank conservativeness is developed in this paper. Unlike Lohmann (1992) and Rogoff (1985a), we are able to express the upper and lower bounds of the interval containing the optimal degree of conservativeness in terms of the structural parameters of the model. Next, we show that optimal central bank independence is higher, the higher the natural rate of unemployment, the greater the benefits of unanticipated inflation, the less inflation-averse society, the smaller the variance of productivity shocks, the smaller real exchange rate variability and the smaller the openness of the economy. These propositions are tested for nineteen industrial countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, New Zealand, the Netherlands, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States) for the Bretton-Woods period and after (1960-1993). In testing the model we employ a latent variables method (LISREL) in order to distinguish between actual and optimal monetary regimes.Central Banks;Credibility;Independence;monetary economics

Learning About the Term Structure and Optimal Rules for Inflation Targeting

In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. We find that under flexible inflation targeting and uncertainty in the degree of persistence in the economy, allowing for active learning possibilities has effects on the optimal interest rate rule followed by the central bank. For a wide range of possible initial beliefs about the unknown parameter, the dynamically optimal rule is in general more activist, in the sense of responding aggressively to the state of the economy, than the myopic rule for small to moderate deviations of the state variable from its target. On the other hand, for large deviations, the optimal policy is less activist than the myopic and the certainty equivalence policies.Learning;Rational Expectations;Separation Principle;Term Structure of Interest Rates

Heterogeneous Information about the Term Structure of Interest rates, Least-Squares Learning and Optimal Interest Rate Rules for Inflation Forecast Targeting

In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework.Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - i.e. the central bank and private agents - who have different information sets about the future sequence of short-term interest rates.We analyse inflation forecast targeting in two environments.One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector interest rate expectations are generated, and one in which the central bank has imperfect knowledge and has to learn the private sector forecasting rule for short-term interest rates.In the case of imperfect knowledge, the central bank has to learn about private sector interest rate expectations, as the latter affect the impact of monetary policy through the expectations theory of the term structure of interest rates.Here following Evans and Honkapohja (2001), the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter.We find that optimal monetary policy under learning is a policy that separates estimation and control.Therefore, this model suggests that the practical relevance of the breakdown of the separation principle and the need for experimentation in policy may be limited.information;term structure of interest rates;least squares;optimization;inflation;forecasting;learning;rational expectations;kalman filter

Learning about the Term Structure and Optimal Rules for Inflation Targeting

In this paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework.We find that under flexible inflation targeting and uncertainty in the degree of persistence in the economy, allowing for active learning possibilities has e®ects on the optimal interest rate rule followed by the central bank.For a wide range of possible initial beliefs about the unknown parameter, the dynamically optimal rule is in general more activist, in the sense of responding aggressively to the state of the economy, than the myopic rule for small to moderate deviations of the state variable from its target.On the other hand, for large deviations, the optimal policy is less activist than the myopic and the certainty equivalence policies.Learning;Rational Expectations;Separation Principle;Term Structure of Interest Rates

Incentive Contracts for Central Bankers under Uncertainty: Walsh-Svensson Non-Equivalence Revisited

We look at the implications of uncertain monetary policy preferences for the targeting and contracting approach to monetary stability. It turns out that in presence of uncertain preferences a linear incentive contract in the sense of Walsh (1995) performs better in terms of social welfare than an explicit inflation target as proposed by Svensson (1997). The reason is that, although both approaches can get rid of the inflationary bias, the impact of uncertain preferences on the variance of inflation will be considerably higher with an inflation target. We also find that on top of an optimal linear contract or target, a quadratic contract, in the sense of Rogoff's (1985) "weight-conservative" central banker, improves the outcome. In the case of an inflation target, a more conservative banker is needed than with a Walsh contract.non-linearities;economic fluctuations;inflation targets;optimal contracts

Why Money Talks and Wealth Whispers: Monetary Uncertainty and Mystique

This paper analyzes the effect of monetary uncertainty on the inflationary bias and the variance of output and inflation. Monetary policy uncertainty is modeled as a shock to the central banker’s preference for inflation stabilization relative to output stabilization that cannot be observed by the public. We find that the mean and variance of inflation increase with the variance of this preference shock. However, unlike other studies, we find that monetary uncertainty may very well have a positive effect on output stabilization and therefore also on society’s welfare.credibility;flexibility;uncertainty