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Explicit inflation targets and central bank independence: friends or foes?

  • Andrew Hallett

    ()

  • Jan Libich

    ()

The paper studies the relationship between two institutional innovations in monetary policy of the past few decades: central bank independence (CBI) and explicit inflation targeting (EIT). The aim is to make inferences about the optimal institutional design of monetary policy, and the right sequencing of policy reform. Our reduced-form model unifies several approaches in the literature, and offers three novel institutional findings (that we square with existing empirical evidence). First, instrument-CBI is a complement to EIT, whereas goal-CBI acts as a strategic substitute for EIT in ensuring low inflation and policy credibility. Second, out of these two ‘commitment technologies,’ EIT is shown to be socially superior to goal-CBI. Third and controversially, countries that first implement goal-CBI are then less likely to adopt the desirable EIT regime. This is because independent central bankers may have less need to do so (their independence partly substitutes for EIT), as well as less willingness to do so (due to a higher degree of accountability associated with a transparently legislated target). Our analysis therefore implies that developing and emerging market countries should go down the New Zealand route—legislate EIT together with instrument-CBI, but stay clear of goal-CBI. Unfortunately, many transition countries have followed the opposite Fed/Bundesbank route, which we show may have adverse welfare consequences through several channels. Copyright Springer Science+Business Media, LLC. 2012

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File URL: http://hdl.handle.net/10.1007/s10644-011-9118-8
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Article provided by Springer in its journal Economic Change and Restructuring.

Volume (Year): 45 (2012)
Issue (Month): 4 (November)
Pages: 271-297

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Handle: RePEc:kap:ecopln:v:45:y:2012:i:4:p:271-297
Contact details of provider: Web page: http://www.springerlink.com/link.asp?id=113294

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