An Independent Central Bank Faced with Elected Governments

Working Paper: CEPR ID: DP2219

Authors: Maria Demertzis; Andrew J. Hughes Hallett; Nicola Viegi

Abstract: The literature argues that the benefits of an independent Central Bank accrue at no cost to the real side. In this paper, we argue that the lack of correlation between monetary autonomy and output variability is due to the proactive role of fiscal policy when faced with rigid monetary objectives. None of the attempts in the literature to measure these correlations allow for a changing fiscal role. As monetary policy is handled by an independent authority, fiscal and wage/social protection policies remain an instrument in the hands of national governments. We find that so long as the two authorities pursue their goals independently of each other, a conflict arises which is exacerbated as preferences diverge. Further to that we find that the establishment of a conservative Central Bank encourages more left-wing preferences amongst the public (as reflected in the governments they elect). And the election of more left-wing governments makes it more difficult for each authority to reach their own preferred objectives, unless they are able to cooperate.

Keywords: central bank independence; accountability; fiscal policy; political uncertainty

JEL Codes: E52; E63; F42

Causal Claims

Cause	Effect
monetary policy (E52)	conflicts that undermine effectiveness of both policies (D74)
fiscal policy (E62)	conflicts that undermine effectiveness of both policies (D74)
conservative central bank (E58)	divergence in preferences among policymakers (D72)
divergence in preferences among policymakers (D72)	conflicts that weaken effectiveness of both fiscal and monetary policies (E62)
independent central bank (E58)	election of more liberal governments (P39)
election of more liberal governments (P39)	fiscal policy decisions (E62)
independent central bank (E58)	median voter preferences focused on employment and growth (E69)