Optimal Commitment in an Open Economy: Credibility vs. Flexibility

Sylvester Eijffinger and Eric Schaling (eric.schaling@wits.ac.za)

Bank of England working papers from Bank of England

Abstract: The theoretical argument for central bank independence is based on the idea that even if the government represents people's preferences over inflation and output it has an incentive to renege from prearranged plans to gain a short run boost to output. This incentive leads to higher than desired inflation. One solution to this credibility problem is to give control of monetary policy to an independent central bank that is more averse to inflation than society. Central bank independence thus reduces society's credibility problem but this may be at the expense of less flexible countercyclical monetary policy. The aim of this paper is to find the correct balance between credibility and flexibility, ie the optimal degree of central bank independence. The first part of the paper sets out an open economy model and identifies some macroeconomic factors that influence the optimal degree of independence. It finds that the optimal degree of independence increases when; 1) the NAIRU is higher, 2) the benefits of unanticipated inflation are greater, 3) society is less inflation-averse, 4) productivity shocks have smaller variance, 5) the real exchange rate has less variability, 6) the economy is less open. The second part of the paper estimates the relationship between these six factors and measures of central bank independence for 19 industrial countries using a latent variables estimation technique. It finds that, in general, the actual degree of independence is related to these six factors and so the institutional arrangements in most countries are close to the optimum. The main exceptions are Germany and Switzerland - that seem to have an excessively high degree of independence - and Australia, Norway, Sweden and the UK - which have a lower than optimal degree of independence.

Date: 1995-12
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://www.bankofengland.co.uk/archive/Documents/h ... papers/1995/wp41.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1995/wp41.pdf [301 Moved Permanently]--> https://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1995/wp41.pdf)

Related works:
Working Paper: Optimal commitment in an open economy: Credibility vs. flexibility (1997)
Working Paper: Optimal commitment in an open economy: Credibility vs. flexibility (1995)
Working Paper: Optimal commitment in an open economy: Credibility vs. flexibility (1995)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:41

Access Statistics for this paper

More papers in Bank of England working papers from Bank of England Bank of England, Threadneedle Street, London, EC2R 8AH. Contact information at EDIRC.
Bibliographic data for series maintained by Digital Media Team (webmaster@bankofengland.co.uk).