Download central bank

JEM027
Monetary Economics
Central bank‘s independence,
transparency and accountability
Tomáš Holub
[email protected]
November 23, 2015
Partly based on presentation of K. Šmídková from the previous year
Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague
Best practice for central bank institutional design
▪ What is the best practice, if you want to establish
a „good“ central bank?
▪ How did we arrive to this best practice ?
▪ What does the economic literature tell us about
the optimal institutional design?
▪ Does good institutional design lead to better actual
performance?
-------▪ Seminar topic: how to measure CB independence
and transparency?
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Best practices for institutional framework
▪ Framework should consist of three pillars
– Independence
– Accountability
– Transparency
▪ Each has specific, but inter-related roles
– Prevent inflation surprises, anchor inflation
expectations
– Avoid the „inflation-freaks“ problem and
deflation surprises, reduce the democratic
legitimacy deficit
– Anchor expectations, increase efficiency
of transmission, reduce the democratic deficit
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Four players in the framework
Parliament
Government
Central bank
Central bank interacts
with three players
within the institutional
framework
Public
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Central bank and government
Parliament
Central bank
No dependence
Government
Government: should
not intervene
(no inflation surprises)
Public
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Central bank and parliament
Parliament
Independence
Central bank
Accountability
No dependence
Government
Parliament grants
independence to
central bank and it
holds central bank
accountable (no
„inflation-freaks“)
Public
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Central bank and public
Parliament
Independence
Central bank
Accountability
No dependence
Government
Public should have all
information (to anchor
expectations and
make transmission
efficient)
Transparency
Public
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Current practice: product of high inflation
16
550
World
Advanced Economies
350
Emer.& Develop. Eco.
Cent. & East. Europe
250
CIS
Developing Asia
150
Mid.East & N. Africa
Western Hemisphere
50
Annual CPI inflation in %
450
12
10
8
6
4
2
0
-50
▪
▪
2009
2004
1999
1994
1989
1984
1979
1974
1969
2009
2004
1999
1994
1989
1984
1979
1974
-2
1969
Annual CPI inflation in %
Advanced Economies
14
Previous approach to monetary policy led to suboptimal outcomes
Problems
– Hyperinflations (South America; some post-communist countries)
– High inflation in advanced countries (1970’s to early-1980’s)
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Increasing central bank independence
Source: Arnone M et al 2007. "Central Bank Autonomy: Lessons from Global Trends," IMF Working Papers
07/88, International Monetary Fund.
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Convergence in central bank independence
Source: Walsh (2007)
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Increasing central bank transparency
Source: http://eml.berkeley.edu/~eichengr/Dincer-Eichengreen_figures&tables_2014_9-4-15.pdf.
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Independence and accountability in theory
▪ Kydland, Prescott (1977): „Discretionary policy … will not
typically result in the social objective function being
maximized.“– strong argument for rule-based policy
▪ Barro, Gordon (1983): show that if central bank has the same
loss function as government, economic agents will expect
inflation surprises – strong argument for independence
▪ Rogoff (1985): shows that conservative (i.e. independent
and inflation-averse) central bank can reduce these inflation
surprises and anchor inflation expectations
▪ Walsh (1995): the central banker should have an adequate
contract with the public to avoid inflation surprises fully, and
at the same time achieve an optimal response to shocks
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Political-economy argument for independence
▪ Short-term political motivations may not be conducive for
achievement of long-run monetary policy goals;
▪ Kydland, Prescott (1977); Barro, Gordon (1983);
▪ Politicians try to fool people (promise low inflation, but later
on inflate to increase seigniorage and employment);
▪ Reasons: misusing short-term benefits, costs visible in the
long run only; pretending good supply-side policies; focusing
on unemployed as a “swing-voter” group;
▪ But people sooner or later recognize this and incorporate it
into their expectations  inflationary bias;
▪ No positive benefits in terms of higher long-term employment;
▪ Rule-based policy can thus be better than discretions.
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Dynamic inconsistency – graphical illustration
▪ With zero inflation

E
B
A
Unemployment
expectations, B is better
than A;
▪ But B is not a long-run
equilibrium: inflation
accelerates and
expectations shift
upwards;
▪ Eventual outcome is E,
i.e. much worse than A;
▪ Optimal policy leads to
sub-optimal outcome.
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Barro-Gordon model
Expectations are rationale
Output equation (Phillips curve)
… where
▪ y* is long-run equilibrium output (absence of
shocks)
▪ πE is expected inflation
▪ zt is supply shock (e.g. oil prices)
▪ εt is technology shock (short-run equilibrium: y*+ε)
▪ a is slope of the Phillips curve (assumed to be 1)
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Barro-Gordon model: government
Loss function of the government (two targets)
… where
▪ y** is long-term targeted output
▪ χ [chi] determines the (relative) importance of inflation target
Assumption for targeted output
Government policy: to achieve higher than equilibrium output
(k is positive)
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Barro-Gordon model: central bank
Central bank is not independent, it has the same loss function
as the government
Loss function (after substitution)
Monetary policy in the model: central bank directly controls
inflation (i.e. minimizes loss function wrt. inflation)
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Barro-Gordon model: optimization
Optimization
Outcome of the optimization
Expected inflation by agents is equal to expected reaction
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Barro-Gordon model: conclusions
▪ If the central bank is not independent (it follows the
government policy), we have an inflationary bias
Expected inflation is not zero
On average inflation is not zero (by substitution)
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Barro-Gordon model: graphical illustration
▪ In equilibrium:
π
inflation equals to
expectations on
average (z is zero
on average)
▪ In equilibrium:
E
Slope: 1/(1+χ)
k/(1+χ)
inflation is above
optimum (i.e.
zero)
▪ This is a selfTarget
k/χ
πE
fulfilling credibility
problem.
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Possible solutions in the literature
▪ Reputation
– Can it really work if the central bank is under political
control (short election cycle)?
▪ Fixed exchange rate
– Soft pegs vulnerable to self-fulfilling attacks; Hard pegs
very rigid (no response to supply-side shocks)
▪ Delegation to conservative central banker
– Rogoff (1985); BuBa usually given as an example; lower
inflation, but less stable real economy (inflation freaks)
▪ Optimal contract with central banker
– Walsh (1995); RBNZ often given as an example; but the
optimal contract rewards deflation – couldn‘t it go too far?
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Fixed exchange rate as a policy rule
▪ A soft peg can lead to
E()
k/(1+)
2
3
slope 1/(1+)
lower inflation (point 3),
1
but at the cost of:
(i) inability to react to
shocks in normal times
slope 1/(1+) (the peg is adjustable
only if shocks are large);
(ii) risk of self-fulfilling
currency crisis (Obstfeld,
1996);
▪ Hard pegs are more
robust, but very rigid –
no response to shocks
E
k/

at all.
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Rogoff: conservative central banker
Central bank is independent and decides according to its own
loss function
The appointed central banker is ˮconservative“, i.e.:
More emphasis put on inflation target (wrt. to targeted output)
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Rogoff: conclusions
Expected inflation is lower than in the “not independent bank”
case
On average inflation is also smaller
Very conservative banker (high χCB): inflation close to zero,
but also weak response to supply-side shocks (i.e. these
shocks feed less into inflation and more into output)
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From Barro to Rogoff: graphical illustration
▪ In equilibrium:
π
inflation equals
to expectations
▪ In equilibrium:
inflation is closer
to optimum (i.e.
zero)
E
k/(1+χCB)
Target k/χCB
Slope: 1/(1+χCB)
πE
▪ The real
economy
becomes more
volatile
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Walsh: optimal contract for central banker
Central bank decides according to the same loss function as
government
However, there is a wage contract between the central banker
and public
(remember we put a=1)
Hence, the total central banker’s loss is
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Walsh: central bank
Loss function (after substitution)
Optimization
Central banker reaction function
Note: k disappears
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Walsh: conclusions
▪ The properly defined wage contract removes inflation bias
fully
Expected inflation is zero
On average inflation is zero, the response to shocks is optimal
▪ Recall: one must know a (=slope of the Phillips curve) to
define the contract, and to be sure that the central banker has
the same loss function as the gov‘t – in practice not easy
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From Barro to Walsh: graphical illustration
π
▪ In equilibrium: inflation
equals to expectations
▪ In equilibrium: inflation
E
is zero on average
▪ Real economy does not
Slope: 1/(1+χ)
Target
become more volatile
πE
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Remarks on accountability
▪ Accountability matters: contract suggested by Walsh (1995)
prevents inflation surprises fully
▪ Example from practice: RBNZ in 1990’s
▪ BUT deflation pays off (!)... moral hazard issue
▪ Accountability is needed to ensure that the target of a central
banker and the one of a central bank are the same
▪ In practice, central banks are held accountable by more
complex procedures than the Walsh-type of the contract
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Does independence help to keep inflation low?
Average inflation: 1955-88
Source: Alesina, A. Summers, L., Central Bank Independence and Macroeconomic Performance: Some
Comparative Evidence, Journal of Money, Credit and Banking, N°25, 1993.
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Does independence help to keep inflation low?
But: Once you control for a country‘s average inflation in the earlier
period, any impact of central bank reform disappears.
Source: Walsh (2007)
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Summary
▪ If a central bank is sub-ordinated to the government, it is tempted
to generate inflationary surprises.
▪ This feeds into people‘s expectations and generates a self-fulfilling
credibility problem (inflationary bias).
▪ Solution: central banks independence, counter-balanced by clear
monetary policy rules, transparency and accountability.
▪ The debate has shifted from rules vs. discretion to rigid vs. flexible
rules.
▪ Fixed ER: preference of hard pegs (rigid rules) due to danger
of self-fulfilling crises
▪ Autonomous MP: preference of flexible rules (e.g. inflation
targeting – subject of the next lecture).
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Selected references
▪ Barro, Gordon 1983. ”Rules, Discretion and Reputation in a Model of Monetary Policy,” JME.
▪ 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.
▪ Alesina, A. Summers, L. 1993. ”Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of
Money, Credit and Banking, N°25.
▪ Walsh, Carl 1995. ”Optimal Contracts for Central Bankers,” American Economic Review, 85, 150-167.
▪ Obstfeld, M. 1996. “Models of Currency Crises with Self-fulfilling Features,” European Economic Review, vol. 40 (April), pp. 1037-48.
▪ Cihak, Holub 1999. ”The Economic Theory of Central Bank Independence,” The Czech Journal of Finance and Credit, 49.
▪ Mahadeva L., Sterne G. 2000. ”Monetary policy framework in a global context,” Routledge, London.
▪ Geraats P. M. 2001. ”Why adopt transparency? The publication of central bank forecasts,” ECB Working Paper No. 41
▪ Frederic S. Mishkin 2004. ”Can Central Bank Transparency Go Too Far?,” NBER Working Papers 10829, National Bureau of Economic
Research, Inc.
▪ Alex Cukierman 2007. ”The limits of transparency,” Proceedings, Federal Reserve Bank of San Francisco.
▪ Arnone M et al 2007. ”Central Bank Autonomy: Lessons from Global Trends,” IMF Working Papers 07/88, International Monetary Fund.
▪ Walsh 2007. Infl‡ation Targeting and the Role of Real Objectives.“ http://people.ucsc.edu/~walshc/MyPapers/Real_Objectives_CCB_09_2007.pdf
▪ Geraats P. M. 2009. ”Trends in Monetary Policy Transparency,” CESifo Working Paper Series 2584, CESifo Group Munich.
▪ Dincer and Eichengreen 2013. Central Bank Transparency and Independence: Updates and New Measures, BOK Working Paper No.201321 (2013.09)
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