Working Paper: CEPR ID: DP752
Authors: Michele Fratianni; Jorgen von Hagen; Christopher Waller
Abstract: An inflation and stabilization bias may arise as a result of the principal-agent nature of monetary policy. Both depend on the degree of political uncertainty and the type of relationship between central bankers and the incumbent political leaders. Specifically, our analysis indicates how a close relationship between central bankers and incumbent political leaders can lead to undesirable outcomes, particularly so during periods of electoral competition and political uncertainty. Various institutional proposals exist for resolving this problem. Our analysis shows that in contrast to Friedman-type policy rules or the appointment of `conservative' central bankers, personal independence of the central banker from government or performance-orientated compensation packages can achieve both optimal stabilization and the elimination of the inflation bias.
Keywords: monetary policy; political business cycles; central banking
JEL Codes: E31; E32; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Close relationship between central bankers and incumbent political leaders (E58) | undesirable economic outcomes during electoral competition and political uncertainty (D72) |
| Personal independence of the central banker from the government (E58) | optimal stabilization and elimination of inflation bias (E63) |
| Performance-oriented compensation packages (J33) | optimal stabilization and elimination of inflation bias (E63) |
| Electoral uncertainty (D79) | high inflation rates (E31) |
| Degree of central bank independence (E58) | average inflation rates (E31) |