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Optimal Commitment in an Open Economy: Credibility vs. Flexibility


  • Sylvester Eijffinger
  • Eric Schaling


The theoretical argument for central bank independence is based on the idea that even if the government represents people's preferences over inflation and output it has an incentive to renege from prearranged plans to gain a short run boost to output. This incentive leads to higher than desired inflation. One solution to this credibility problem is to give control of monetary policy to an independent central bank that is more averse to inflation than society. Central bank independence thus reduces society's credibility problem but this may be at the expense of less flexible countercyclical monetary policy. The aim of this paper is to find the correct balance between credibility and flexibility, ie the optimal degree of central bank independence. The first part of the paper sets out an open economy model and identifies some macroeconomic factors that influence the optimal degree of independence. It finds that the optimal degree of independence increases when; 1) the NAIRU is higher, 2) the benefits of unanticipated inflation are greater, 3) society is less inflation-averse, 4) productivity shocks have smaller variance, 5) the real exchange rate has less variability, 6) the economy is less open. The second part of the paper estimates the relationship between these six factors and measures of central bank independence for 19 industrial countries using a latent variables estimation technique. It finds that, in general, the actual degree of independence is related to these six factors and so the institutional arrangements in most countries are close to the optimum. The main exceptions are Germany and Switzerland - that seem to have an excessively high degree of independence - and Australia, Norway, Sweden and the UK - which have a lower than optimal degree of independence.

Suggested Citation

  • Sylvester Eijffinger & Eric Schaling, 1995. "Optimal Commitment in an Open Economy: Credibility vs. Flexibility," Bank of England working papers 41, Bank of England.
  • Handle: RePEc:boe:boeewp:41

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    References listed on IDEAS

    1. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
    2. David Romer, 1993. "Openness and Inflation: Theory and Evidence," The Quarterly Journal of Economics, Oxford University Press, vol. 108(4), pages 869-903.
    3. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-286, March.
    4. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
    5. 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.
    6. Manfred Neumann, 1991. "Precommitment by central bank independence," Open Economies Review, Springer, vol. 2(2), pages 95-112, June.
    7. Alesina, Alberto & Summers, Lawrence H, 1993. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(2), pages 151-162, May.
    8. Layard, Richard & Nickell, Stephen & Jackman, Richard, 2005. "Unemployment: Macroeconomic Performance and the Labour Market," OUP Catalogue, Oxford University Press, number 9780199279173.
    9. Cukierman Alex, 1992. "Central Bank Strategy, Credibility, And Independance: Theory And Evidence," Journal des Economistes et des Etudes Humaines, De Gruyter, vol. 3(4), pages 1-10, December.
    10. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    11. S. Eijffinger & M. Van Keulen, 1995. "Central bank independence in another eleven countries," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 48(192), pages 39-81.
    12. Eijffinger, S.C.W. & Schaling, E., 1993. "Central bank independence : Theory and evidence (Revised version)," Discussion Paper 1993-25, Tilburg University, Center for Economic Research.
    13. Eijffinger, S.C.W., 1993. "Central bank independence in twelve industrial countries," Other publications TiSEM 0401b17a-e2c7-4179-ace9-a, Tilburg University, School of Economics and Management.
    14. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
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    Cited by:

    1. Alexander Mihailov, 2007. "Does Instrument Independence Matter under the Constrained Discretionof an Inflation Targeting Goal? Lessons from UK Taylor Rule Empirics," Money Macro and Finance (MMF) Research Group Conference 2006 95, Money Macro and Finance Research Group.

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