Central bank independence and inflation—Old story told anew

• Author: Joanna Mackiewicz‐Łyziak,Ryszard Kokoszczyński
• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1002/ijfe.1730

RESEARCH ARTICLE

Central bank independence and inflation—Old story

told anew

Ryszard Kokoszczyński | Joanna Mackiewicz‐Łyziak

Faculty of Economic Sciences, University

of Warsaw, ul. Długa 44/50, Warsaw 00‐

241, Poland

Correspondence

Joanna Mackiewicz‐Łyziak, Faculty of

Economic Sciences, University of Warsaw,

ul. Długa 44/50, Warsaw 00‐241, Poland.

Email: jmackiewicz@wne.uw.edu.pl

Abstract

Central bank independence (CBI) and its link to inflation have become a part

of conventional wisdom. However, the literature shows that there is a lack of a

stable general pattern for the relation between CBI and inflation, even for rel-

atively homogenous groups of countries. In this study, we use two indexes for

CBI proposed in the literature. For the panel of 51 countries (24 advanced and

27 nonadvanced economies), we estimate two regression models—one with

inflation as a dependent variable and another with inflation gap in this role.

We use two estimation methods: the panel fixed effects model with serial auto-

correlation in the error term and the Arellano‐Bond difference generalized

method of moments estimator. In addition, we use disaggregated indices to

check what aspects of independence are of highest importance. Our results

suggest that CBI has a negative significant impact on inflation mostly by results

for nonadvanced economies and that this relationship did not change during

the recent crisis.

KEYWORDS

Advanced and nonadvanced economies, central bank independence, dynamic panel data models,

global financial crisis, inflation, inflation gap

JEL CLASSIFICATION

E31; E58

1|INTRODUCTION

Central bank independence (CBI) and its link to inflation

have become a part of conventional wisdom in economics.

It is most often explained by the time inconsistency of opti-

mal policy and inflationary bias of the government when

the latter is responsible for both the real economic activity

and nominal stabilization. Seminal papers by Kydland and

Prescott (1977), Barro and Gordon (1983), and Rogoff

(1985) have shown simple and consistent theoretical

framework justifying—with the time inconsistency of

optimal monetary policy—delegation of responsibility for

a price stability to an independent central bank. Goodhart

(2003) and Gnan and Masciandaro (2016) present the

same story in a more narrative manner to make it under-

standable for the general public.

Validity of the link between CBI and inflation can be

empirically tested only when CBI is quantified. The most

popular approach to measuring CBI is to create an index

based on expert assessment of various dimensions of CBI:

legal, personal, economic, financial etc. The index

designed by Grilli, Masciandaro, and Tabellini (1991)

and another index constructed by Cukierman, Webb,

and Neyapti (1992) are most widely used in the literature.

The former includes 15 components that are divided into

two groups measuring respectively economic and political

independence, the latter includes 16 components and

they form four groups measuring the governor's political

Received: 7 March 2018 Revised: 25 October 2018 Accepted: 21 March 2019

DOI: 10.1002/ijfe.1730

wileyonlinelibrary.com/journal/ijfe

IntJ Fin Econ.2020;25:72–89.

© 2019 John Wiley & Sons, Ltd.

72

independence, monetary policy process (its design and

resolution of potential conflicts), objectives of the central

bank, and limits for central bank's lending to the

government.

The first wave of empirical work directed into finding

a meaningful relation between CBI—as measured with

those indexes—and inflation did not bring fully satisfac-

tory results. Both teams that introduced CBI indexes, that

is, Grilli et al. and Cukierman et al., ran regressions on

inflation using their indexes, and they found them

negatively correlated with inflation, though not for all

countries in their samples and not for the overall periods

they studied. Later papers showed qualitatively similar

results, and further developments went in two different

directions. The first one was the search for the conditions

that might make CBI statistically significant in the infla-

tion regression. That mostly took the form of introducing

more covariates into this regression motivated mainly by

ad hoc arguments, for example, growth dynamics, labour

market variables, level of development, and political and

social variables. The latter choice was to some extent sup-

ported by the second direction of further developments,

that is, by the political‐economy approach to the problem

of CBI where its impact on inflation was conditional on

institutional features of the economy.

All these extensions of empirical strategies were not

successful in bringing fully unambiguous results for the

shape and strength (or even for the sheer existence) of

the relation between CBI and inflation. As our literature

review presented below shows it is still difficult to obtain

a negative and statistically significant effect on inflation

of CBI across all groups of countries and time periods.

This lack of a stable general pattern for this relation, even

for relatively homogenous groups of countries, has

become our initial motivation for the study we present

below.

Another strand of the debate on CBI and inflation that

influences our study is due to major central banks engag-

ing themselves into so‐called unconventional monetary

policy during the great financial crisis. As some of those

activities seem to go beyond the specific mandate that

justifies theoretically CBI itself, natural outcome ques-

tions arise about the limits of that independence: should

it cover only the narrowly defined monetary policy or

should it also include other central bank activities going

beyond that, including macroprudential policy (cf.

Blinder, Ehrmann, de Haan, & Jensen, 2017; de Haan &

Eijffinger, 2016, 2017; Issing, 2016; Mersch, 2017). Most

discussants give a clear answer that the concept of CBI

applies only to the central bank as a monetary policy

institution. However, those extensions of central bank

functions that are mentioned earlier have been accompa-

nied by changes in central bank laws and regulations (cf.

Khan, 2017). Thus, it is a valid question to check whether

different measures of CBI have showed some changes for

the crisis and after‐crisis period and whether the link

between CBI and inflation has changed its nature after

the crisis. For example, for the turnover rate, Artha and

de Haan (2015) find that financial crises increase the

probability of a central bank's governor turnover.

Hence, our contributions to the existing literature may

be summarized as follows. First, we use two measures of

legal CBI for the same sample of countries and the same

period. Our results suggest, in opposition to many earlier

studies, that the legal CBI is important in lowering

inflation in nonadvanced economies, whereas it is insig-

nificant in advanced ones. Moreover, although both indi-

ces produce almost the same results in terms of sign and

statistical significance of the relationship, there are some

significant differences in the estimated strength of the

relationship, which suggests that focusing on only one

measure of CBI may give uncertain results.

Second, in addition to the analysis of the link between

CBI and inflation rate, we investigate the link between

CBI and inflation gap. As the inflation gap, we under-

stand the deviation of inflation from inflation target

(details are described below). The reason for such treat-

ment of the dependent variable is that our sample period

includes episodes of very low or even negative inflation

rates in some of the countries. This could bias our results

on the basis of inflation rate, as the assumption that the

central banks may aim at such low inflation rates seems

implausible. This is a novel approach to analysis of the

macroeconomic effects of CBI and, to our knowledge,

firstly used in the literature. Most recently, Nurbayev

(2017) goes beyond investigating the relationship between

CBI and the level of inflation, and he studies the relation-

ship between inflation volatility and CBI (and the rule of

law). However, with inflation at the very low levels, infla-

tion volatility is also likely to be very low. Our approach

assumes thus that central banks aim at inflation rates at

target levels (low but positive).

Third, as we have at our disposal disaggregated data on

the CBI indices (subindices constituting the CWN and

GMT measures), we check what aspects of CBI have

effect on inflation and inflation gap in advanced and

nonadvanced economies. Similar analysis is performed

by Balls, Howat, and Stansbury (2016), although they dis-

tinguish only between political and operational indepen-

dence. Similar idea is also used by Crowe and Meade

(2008), and they find that having a single well‐defined

inflation or price level target is the only aspect of CBI that

in a statistically significant way influences inflation. Our

analysis suggests that most of the legal aspects of CBI

are important in the nonadvanced economies, whereas

virtually none are in the advanced economies.

KOKOSZCZYŃSKI AND MACKIEWICZ‐ŁYZIAK 73