Working Paper: CEPR ID: DP4911
Authors: Haizhou Huang; Shangjin Wei
Abstract: Weak public institutions, including high levels of corruption, characterize many developing countries. With a simple model, we demonstrate that institutional quality has important implications for the design of monetary policies and can produce several departures from the conventional wisdom. We find that a pegged exchange rate or dollarization, while sometimes prescribed as a solution to the problem of a lack of credibility, is typically not appropriate in developing countries with poor institutions. Such an arrangement is inferior to an optimal inflation targeting, or a Rogoff-style central banker, whose optimal degree of conservatism is proportional to the quality of institutions. Furthermore, our results cast doubt on the notion that a low inflationary target or a currency board can be used as an instrument to induce governments to strengthen quality of public institutions.
Keywords: conservative central banker; corruption; currency board; dollarization; inflation targeting; institutional quality; monetary policy
JEL Codes: E52; E58; E61; E62; H50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| weak institutions (O17) | inappropriate monetary policies (E64) |
| inappropriate monetary policies (E64) | low credibility and potential currency crises (F31) |
| weak institutions (O17) | higher optimal inflation targets (E31) |
| weak institutions (O17) | ineffective incentives for governments to strengthen institutional quality (O17) |
| weak institutions (O17) | less conservative central bankers (E58) |