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Wage Indexation, Central Bank Independence and the Cost of Disinflation

  • Giuseppe DIANA

Recently, Fischer [1996] and Posen [1998] demonstrated empirically that countries with less independent central banks enjoy lower output losses during disinflationary cycles. Since independence is presume to provide a credibility bonus to the monetary policy, this conclusion looks surprising. To explain their paradoxical result, these authors put forward that independent central banks probably face a flatter short-run Phillips curve. In this paper, we provide a formal demonstration of this point. More precisely, we demonstrate that the private sector has less incentive to index its nominal wages when the central bank is granted with a large amount of independence. Since an increased indexation steepens the short-run Phillips curve, our result is consistent with the view that where central bank independence is greater, the cost of disinflation is higher. Our empirical tests, for a sample of 19 OECD countries, support our theoretical analysis. In particular, a negative and significant relationship is found between indexation and independence.

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Paper provided by Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg in its series Working Papers of BETA with number 2000-03.

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Date of creation: 2000
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Handle: RePEc:ulp:sbbeta:2000-03
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  1. Olivier J. Blanchard & Lawrence H. Summers, 1986. "Hysteresis and the European Unemployment Problem," NBER Chapters, in: NBER Macroeconomics Annual 1986, Volume 1, pages 15-90 National Bureau of Economic Research, Inc.
  2. Devereux, Michael, 1987. "The effect of monetary variability on welfare in a simple macroeconomic model," Journal of Monetary Economics, Elsevier, vol. 19(3), pages 427-435, May.
  3. Adam Posen, 1995. "Central bank independence and disinflationary credibility: a missing link?," Staff Reports 1, Federal Reserve Bank of New York.
  4. 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.
  5. Alberto Alesina, 1988. "Macroeconomics and Politics," NBER Chapters, in: NBER Macroeconomics Annual 1988, Volume 3, pages 13-62 National Bureau of Economic Research, Inc.
  6. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  7. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  8. Andreas Fischer, 1996. "Central bank independence and sacrifice ratios," Open Economies Review, Springer, vol. 7(1), pages 5-18, January.
  9. Fischer, Stanley, 1983. "Indexing and inflation," Journal of Monetary Economics, Elsevier, vol. 12(4), pages 519-541, November.
  10. 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 151-62, May.
  11. Fischer, Stanley & Summers, Lawrence H, 1989. "Should Governments Learn to Live with Inflation?," American Economic Review, American Economic Association, vol. 79(2), pages 382-87, May.
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