Central Bank Independence and Inflation: Schumpeterian Theory and Evidence

We first use a monetary Schumpeterian model to investigate how central bank independence (CBI) affects inflation. We find that we cannot predict a monotone relationship between CBI and infiation. When the elasticity of labor supply is high or the seigniorage is mainly used to finance entrepreneurs, a condition that is more likely in developed countries, CBI has a positive effect on inflation; in contrast, when labor supply is inelastic or the seigniorage is mainly used to finance non-productive government spending, a situation more commonly found in developing countries, CBI has a negative effect or no effect on inflation. Calibration shows the following. When the nominal interest rate increases from 8.3% (the sample mean) to the optimal value of 28.1%, the equilibrium rate of economic growth increases from the benchmark value of 1.8% to 1.99%, and the welfare gain is equivalent to a permanent increase in consumption of 1.02%. The growth and welfare effects increase with CBI. As an empirical test, we build panel data for 68 countries during 1998–2010 and find that the effect of CBI on inflation is positive and significant in developed countries, and it is insignificant (at the 5% level) in developing countries in both system generalized method of moments (GMM) and instrumental variable (IV) estimations. Our results remain robust to the consideration of financial crises, financial development, and other factors affecting inflation. Our empirical findings provide support for our theory.