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Should central banks really be flexible?

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Author Info
Hans Peter Grüner () (Universität Mannheim, Fakultät für Rechtswissenschaft und Volkswirtschaftslehre, Dekanat der Abteilung Volkswirtschaftslehre, 68131 Mannheim, Germany.)
Abstract

In this paper I show that central bank flexibility may not be desirable when it encourages trade unions to behave more aggressively. The argument is based on a model where risk averse trade unions interact with a central bank. A flexible central bank stabilizes economic shocks and reduces output volatility. This enables trade unions to realize higher real wages without risking the unemployment of some insider workers. Risk averse insiders demand higher real wages, generate more inflation and more unemployment. The overall effect on welfare may be negative. A conservative central bank instead increases output and employment on average but raises output volatility. The argument also sheds new light on the issue of optimum currency areas. Wage claims are lower and employment is higher in a currency union if national trade unions expect the central bank to do less to secure employment of insider workers in their country. JEL Classification: E52; E58.

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Paper provided by European Central Bank in its series Working Paper Series with number 188.

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Length: 26 pages
Date of creation: Oct 2002
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Handle: RePEc:ecb:ecbwps:20020188

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Related research
Keywords: central bank flexibility; central bank credibility; optimum currency area.;

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  1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121. [Downloadable!] (restricted)
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  2. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November. [Downloadable!] (restricted)
  3. Cukierman, Alex & Lippi, Francesco, 1999. "Central bank independence, centralization of wage bargaining, inflation and unemployment:: Theory and some evidence," European Economic Review, Elsevier, vol. 43(7), pages 1395-1434, June. [Downloadable!] (restricted)
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  4. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March. [Downloadable!] (restricted)
  5. Lippi, F., 2000. "Strategic Monetary Policy with Non-Atomistic Wage-Setters," Papers 374, Banca Italia - Servizio di Studi.
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  6. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March. [Downloadable!] (restricted)
  7. Fratianni, Michele & von Hagen, Jurgen & Waller, Christopher J, 1997. "Central Banking as a Political Principal-Agent Problem," Economic Inquiry, Oxford University Press, vol. 35(2), pages 378-93, April.
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  8. S[empty]rensen, Jan Rose, 1991. "Political uncertainty and macroeconomic performance," Economics Letters, Elsevier, vol. 37(4), pages 377-381, December. [Downloadable!] (restricted)
  9. Gruner, Hans Peter & Hefeker, Carsten, 1999. " How Will EMU Affect Inflation and Unemployment in Europe?," Scandinavian Journal of Economics, Blackwell Publishing, vol. 101(1), pages 33-47, March. [Downloadable!] (restricted)
  10. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December. [Downloadable!] (restricted)
  11. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, vol. 75(3), pages 530-38, June. [Downloadable!] (restricted)
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