1 Central Bank Independence with Inflation Targeting in Developed and Developing Countries Paulo Chananeco F. de Barcellos Neto 1 Alexandre Englert Barbosa 2 Abstract The objective of this work is to discuss the existence of gains in having an independent Central Bank in countries which adopt the Inflation Targeting. The division of the sample into developed and developing countries applied to a structure of a panel data has made possible to demonstrate that in developing countries which adopt the Inflation Targeting and have independent central banks present lower interest rates, whereas in developed countries the results were not statistically conclusive. Additionally, this article presents a brief survey, which concerns about the independence of central banks, in which most of the works done indicate the existence of economic gains for the nations by providing independence for their monetary authorities. Key words: Central Bank Independence, Panel Data, Inflation Targeting System. JEL Classification: E5, E52, E58. 1 Master of Science and PhD student in Economics (PPGE/UFRGS). 2 Master of Science and PhD student in Economics (PPGE/UFRGS). We would like to thank Marcelo Portugal for his comments and suggestions, as well as Fatima Pederzolli for helping us in the translation of this paper.
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1
Central Bank Independence with Inflation Targeting
in Developed and Developing Countries
Paulo Chananeco F. de Barcellos Neto 1
Alexandre Englert Barbosa2
Abstract
The objective of this work is to discuss the existence of gains in having an independent
Central Bank in countries which adopt the Inflation Targeting. The division of the
sample into developed and developing countries applied to a structure of a panel data
has made possible to demonstrate that in developing countries which adopt the Inflation
Targeting and have independent central banks present lower interest rates, whereas in
developed countries the results were not statistically conclusive. Additionally, this
article presents a brief survey, which concerns about the independence of central banks,
in which most of the works done indicate the existence of economic gains for the
nations by providing independence for their monetary authorities.
Key words: Central Bank Independence, Panel Data, Inflation Targeting System.
JEL Classification: E5, E52, E58.
1Master of Science and PhD student in Economics (PPGE/UFRGS).2 Master of Science and PhD student in Economics (PPGE/UFRGS).We would like to thank Marcelo Portugal for his comments and suggestions, as well as Fatima Pederzollifor helping us in the translation of this paper.
2
Introduction
The determination of a function that represents the action of central banks has
been treated in literature based on a reaction function proposed by Taylor (1993). By
adopting the Inflation Targeting System (hereafter ITS), many countries have succeeded
in controlling the inflation rate in a context of flexible exchange rate systems, besides
keeping the Gross Domestic Product of these nations oscillating close to their natural or
potential paths.
In conjunction with the dissemination and the relative success of the
implementation of this monetary policy arrangement, some questions still require
greater investigations. Undoubtedly, one of them is to try to explain why some nations
that have adopted this system present low benchmark interest rates and others need to
coexist with high rates. Certainly, the explanation for these differences lies on a great
amount of complex vectors, such as the level of the current inflation, the size of
economy, the profile and composition of public debts, the credibility in the economic
policy, the degree of economic openness, the conditions of external financing and the
institutional issues.
This article, in particular, aims at discussing the way this last factor, more
specifically the independence of central banks (hereafter CBI), has affected the
determination of the level of basic interest rate in a sample of developed and
developing countries which uses the ITS.
Many studies (Berger et al, 2001; McCallum, 1995; Cukierman, Webb and
Neyapti, 1992; Cukierman, 1992; Alesina and Summers, 1993; Alesina, 1989) were
held with the purpose of observing the relationship between inflation and CBI.
Generally, these works conclude that there is a negative correlation between inflation
3
and CBI. The literature usually takes into account a cross section3 analysis of several
countries, using either questionnaires about legal aspects of central banks and a turnover
index4 as a proxy for the CBI, so as to measure the actual independence, which is
important to developing countries.
In this way, it is expected that in countries which adopt the ITS with an
independent central bank, they present both lower inflation and interest rates, since this
is one of the main instruments for reducing it.
In order to measure this relationship, besides this introduction, this paper
contains three parts: in the second one, a synthesis of the way literature has been
treating the CBI and its relation with inflation will be presented; in the third part, an
econometric model will be estimated, as well as its results will be shown; and finally, in
the fourth part, the conclusions reached along the work will be exposed.
2. Central Bank Independence
Since the late 70’s and the early 80’s, the CBI has become one of the most
discussed issues within the scope of the monetary policy. Its origin is connected to the
dynamic inconsistency model by Kydland and Prescott (1977) and Barro and Gordon
(1983). In short, when the inflation expected is low in such a way that the marginal cost
of growth is reduced, there are incentives for policy makers to adopt expansionist
policies in terms of production, above the level of long run balance.
However, as the economic growth presents rational expectations, the behavior of
the bank is anticipated. Thus, besides the fact that the results in terms of growth of the
product do not occur, an increase of prices takes place, revealing a neutral behavior of
3 Works focusing only on one country were also carried out. See, for example, Panagiotidis andTriampella (2001) for an approach about the impacts of CBI on Greece.
4
money. Therefore, a central bank which is not disconnected from the political interests
of the government may be dissuaded from implementing such policies, namely the
increase of money supply.
Constant temptations for policy makers to rise the economic growth, to request
the covering of budget deficits of the government by issuing money, and to generate
inflation by fiscal authorities are some of the traps that should be avoided by society,
taking into consideration the inflationary results. Considering these facts, some authors,
as McCallum (1995), defend the idea that one of the greatest advantages of
independence of these institutions is the isolation of the usual decisions of the monetary
policy from the pressures of political activity, inherent in the democratic process.
Rogoff (1985) adds that besides an independent central bank, this should be
conservative, referring to the fact that the “banker” should be more averse to risk than
the government.
More specifically, the first motivation mentioned above – of economic growth
via expansionist monetary policy – is related to the political cycle, which in this context,
may act by means of incoherent actions with the goals of the current monetary policy in
a country, such as the reduction of interest rates during pre-electoral periods in the
search of a short-run economic growth, despite of the consequences in terms of loss of
credibility which will have to be faced in the future. In relation to government deficits
covered by increases of money supply in its different forms, the risk is similarly high;
by the way, the economic literature has demonstrated that this has been the main cause
of hyperinflations observed throughout economic history, what makes the discussion
about CBI still more and more relevant.
According to Blinder (1998), the importance of an independent central bank lies
on the fact that by its own nature the monetary policy needs a long term horizon, which
4 It measures the turnover of central banks chairmen.
5
indeed has not been observed neither by politicians, nor by society, who most of the
time are not even aware of the terrible effects a badly conducted monetary policy may
bring about.
The CBI can also be interpreted as the increase of the weight attached to the
objective of reducing inflation, in the sense used by Rogoff (1985). Yet, Alesina and
Summers (1993) and Eijffinger and Schalling (1993) have not identified any
relationship between the CBI and the volatility of the real economy for industrialized
countries, what cannot be seen as a contradiction5. In this way, there would be a free
lunch due to the CBI, reducing the inflation and at the same time not increasing the
output volatility. This could reflect either the existence of an inverse relation of cause of
aversion to risk for the CBI or the presence of a third factor responsible for both.
For Fischer (1995), even when there is an inverse relation of cause and effect, it
is probably first-best proposing a legislation to establish an independent central bank for
those who want to reduce inflation, leaving a few doubts that on average the economic
performance is better in countries with higher independence of the monetary authority.
Additionally, it is assumed as true that in industrialized countries, where the legal
clauses are stronger, the relation of cause and effect goes from independence to
reduction of inflation.
As the debate about central banks evolves, within a context of a generalized
increase of the autonomy of decisions of these institutions all over the world, the
discussion of the degree of independence turns out to be so important as the necessity of
independent central banks in their full conception. For this reason, concerning CBI, it is
important to highlight the difference between the independence of objectives and tools.
In the former, the institution determines its own goals to be pursued, instead of being set
by another governmental department. On the other hand, in the latter, the bank has the
6
control over the instruments of the monetary policy (Debelle and Fischer, 1994).
Fischer, 1995 highlights that there is still the differentiation between independence and
autonomy: whereas the former refers to the independence of objectives and instruments
jointly, the latter takes into consideration only the independence of instruments.
In relation to the empirical tests, several works have been held in order to
estimate the effects of CBI over inflation, unemployment, and credibility of monetary
policy. (Cukierman, Webb and Neyapti, 1992; Alesina and Summers, 1993; Alesina,
1989; Grili et al, 1991)6.
Therefore, literature has shown that, for industrialized countries, independent
central banks are negatively correlated with the average inflation. By using a measure
of the CBI which includes formal and informal7 aspects, Cukierman, et al (1992) and
Grilli et al (1991) observe that, in general, there is an inverse relation between
independence and inflation, as well as a lower volatility of the latter. According to
Cukierman et al (1992), in all the countries analyzed, whose annual average inflation
has surpassed 50%, the CBI was below the median. Moreover, the results obtained have
demonstrated that, during the 80’s, the index that measures the independence of central
banks varied from 0.69 (Bundesbank), more independent, to 0.10 (Poland), less
independent.
In the study mentioned, it was noticed that in industrialized countries the
negative correlations between inflation and independence of central banks were higher
then the one calculated for the whole sample (with developed and developing
5 See McCallum (1995) for the reasons of the apparent contradiction.6 For some surveys related to the subject, see Berger et al (2001), Cukierman (1992), and Eijffinger andHann (1996).7 The informal measure consists of a research with Bank staff, comparing the correlation of legalindependence with the answers. In the industrialized countries, the correlation surpassed the one ofdeveloping countries. The focus on formal aspects stems from the pioneering analysis of CBI forindustrialized economies based on questionnaires done by Bade and Parkin(1982).
7
countries). One of the possibilities for such fact to take place is the difference between
the real independence and the legal one. It can be observed a higher correlation between
the questionnaire-based index8 (informal measures of independence) and the legal
aspects (formal measures) for industrialized countries and very low to the entire sample,
what must indicate a minor respect to the legal aspects in developing countries.
Due to the discrepancy in the results of developed and developing countries, it
has been observed that exactly because of this minor tradition in terms of contracts
compliance, for the latter ones, it should have been added a variable capable of
measuring the actual independence, which was not only observed with the legal aspects,
caught by CBI legal index9. Therefore, some studies as Cukierman’s (1992) mentioned
above, included a turnover rate, which takes into account the turnover of the banker in
the post. As it was expected, it was proved that the lower the turnover is, the lower the
inflation in developing countries.
For developed countries, this variable was not significant, even though the CBI
legal index has caught the negative correlation with inflation (Cukierman et al, 1992 and
Cukierman, 1994). The refinement of the turnover measure of the banker was held by
Cukierman (1996), based on the propensity of the chairmen of central banks of losing
their post after political transitions10. Cukierman and Webb (1995) have come to the
conclusion that the average propensity of replacing the banker is higher after political
transitions and also that the vulnerability is greater in developing countries.
Fischer (1995) splits up the measure of independence of central banks into three
components: a) presence of a legal requirement to pursue the monetary stability among
8 Answered by central bank officials.9 The legal aspects were usually measured through questionnaires that referred to chairmen’s mandate andnomination, for instance. They also took into consideration the official objectives of central bank, legalrestrictions of loan obtained by public sector, juxtaposition of mandates. With these characteristicsadequately weighted, an indicator was reached. For more details, see Cukierman (1992).10 It was measured through loss of mandate, six months after the political transition.
8
the objectives of the central bank; b) measures relating the rights of central bank of not
financing the government and establishing the discount rate; and c) a combination of
legal provisions in regard with the relations and commitment of the bank with the
government. The author concluded that the factor which was more linked to the
inflation performance were “a” and “b”.
Nevertheless, the results founded in literature are not unanimous. As the debate
evolved, criticisms arouse referring to the theoretical presuppositions and the own
measurement of the degrees of independence of central banks. Hayo and Hefeker (2001)
assert that the CBI is neither a necessary, nor an enough condition for monetary
stability. Mangano (1998) presents some technical criticism about the structure of the
CBI indexes. Campillo and Miron (1997), through an empirical analysis, do not observe
any relationship between the variation of the average inflation of the countries and the
different degrees of independence of central banks.
According to Pollard (1993), the results of the empirical studies are deficient ,
since: the measurement of the degree of independence is complex; there may be a
spurious relationship between CBI and economic performance; possibility of
endogenous CBI; and the inclusion of periods of fixed exchange rates in some studies,
when the central bank should not be considered as responsible for monetary policy
Despite of some dissonant voices and possible errors committed during
measurement, the empirical results insist on showing that the CBI is indeed a way of
reducing inflation with low costs for society, besides increasing the degree of credibility
of the monetary policy throughout the time. In this sense, specially after the Golden and
Silver Standards and the Bretton Woods System, when the central banks became even
more responsible for the inflationary control, the CBI has been a measure adopted in
some countries to reduce inflation and its variability.
9
3. Independence of Central Banks and Inflation Targeting System
As it was discussed in the previous section, a great part of literature that
concerns about the estimates of the effects of CBI in countries that adopt this measure is
centered in its own effects over the inflation. However, in this work, the focus is to
estimate the effects that independence exerts on the benchmark interest rate in a sample
of ten countries: Australia, Brazil, Canada, Chile, Colombia, South Korea, England,
Mexico, New Zealand and Sweden, whose the main characteristic in common is the fact
of adopting the inflation targeting system (ITS).
3.1 The Model
Probably, the most adequate manner of estimating the impacts that CBI has on
the level of the benchmark interest rate would be developing an individual study for
each country. Yet, because of the limited number of observations for some countries
that have adopted this system and have made modifications in the institutional structure
of their central banks after opting for the system of targets, it was opted to carry out
sectional estimation of panel data.
Mohanly and Klau (2004) have already used these methods to estimate the
effects of the ITS in countries which have adopted them. In particular, the uses of this
method as time and space dimension have been increasing its frequency in literature.
The most simple method of estimation is the one that ignores the structure of panel data,
characterized as sectional data, or models of pooled regression. Based on Taylor’s Rule
10
(1993)11, and making some alterations, the equation to be estimated will have the
following structural form:
itititititit BCICCGapi εβββπβα +++++= 4321 (1)
Where,
iit: quarterly average of the benchmark nominal interest rate of country i in period t:
πit: quarterly average of inflation accumulated in 12 months for country i in period t;
Gapit: quarterly output gap12 of country i in period t;
CCit: dummy variable that assumes unit value when a country i presented a deficit in
current account in the accumulated of quarter;
BCIit; dummy variable that assumes unit value when country i has independent central
bank in quarter t13;
βi:: estimated coefficient vectors
εit: error of regression.
Assuming that εit ~ iid (0,σ2) for all i and t means that for each country, the
observations are not serially related and, for countries and time, the errors are
homosckedastics. This specification can be estimated by the Ordinary Least Squares
Method (OLS), with the traditional interpretations of the validation tests. When the
estimations are considered in cross section, in conjunction with the data in time series in
a panel data structure, the presentation of some peculiarities is necessary. From the
equation (1), a panel structure can be presented in the following way:
itititititiit BCICCGapi εβββπβα +++++= 4321 (2)
Where,
11 A more detailed discussion of a reaction function can be found in Taylor, J (1993). Discretion versuspolicy rules in practice. Carnegie-Rochester Conference Series on Public Policy, p. 195-214.12 The output gap was calculated by using the HP filter and having as a reference the quarterly output inseasonally adjusted level by the authors by means of ARIMA X-12 method.13 In this work, it will be assumed that a central bank is independent when it is guaranteed in thelegislation.
11
αi = α + ui (3)
is the individual effect, constant during the whole time and specific for each country.
The OLS method provides consistent estimates of data if the αi’s are equal for all
countries: on the other hand, when this does not occur, two structures exist that
generalize this model. The first, called fixed effects, considers the term constant in the
regression model, while in the second, named random effects, considers that αi is a
particular group of errors. Thus, the difference between both methodologies is in the
form of treatment of term αi.
The structure of fixed effects assumes that all the differences of behavior
between the countries along the time can be caught by the constant term. Thus, each αi
is an unknown parameter, which can be estimated in two ways. The first is to apply the
Least Squares Dummy Variable (LSDV) method, that confers an unit value for each
country i and the coefficients of αi are equivalent to the intercepts of each country. A
second way, which will be applied in this paper, the within and between estimators. In a
first moment, it is made a transformation in equation (2), estimating a model based on
the average of the exogenous variables and of the endogenous one, with the purpose of
eliminating the effect not observed ui. That is, the following equation is estimated:
iiiiiii uBCICCGapi__
4
_
3
_
2
_
1
_
εβββπβα ++++++= (4)
Where the dashes represent the average of the respective terms of equation (2).
Subtracting the equation (4) from equation (2) for each t, the result is an equation that
represents the deviations of the group’s average, represented by:
The accomplishment of this opening demonstrates an important difference
between the relevance of CBI in developing countries in relation to developed countries
of the sample14. In the first group of countries, the regression presents itself highly
adherent to data with a R2 equal to 0.91 and all the coefficients are significant.
Controlling by the other exogenous variables, the model indicates that having a CBI in
the developing countries group in a context of ITS decisively affects the level of the
benchmark interest rate.
In the case of developed countries, the independence of these institutions are not
significant to explain the level of interest rates of these countries. This result may be
associated to the fact that the specification of the model estimated did not have a good
performance in this group of countries or to the supposition that in developed countries
14 It is assumed as group of developed countries - England, Sweden, New Zealand, Canada and Australia;and as a group of developing countries - Brazil, Chile, Mexico, South Korea and Colombia.
18
the degree of confidence in the institutions is so high that the independence of central
banks ends up by not affecting the level of interest rates adopted in these countries.
Table 3
19
Results of the Pooled Data Estimates for the Stratified Sample between Developedand Developing Countries with ITS
20
21
Developed Countries Developing Countries
Dependent Variable: Benchmark Interest Rate
Pooled Data
π 0.185** (0.082)
1.219*** (0.087)
Gap 0,120*** (0.045)
0.120• (0.083)
CC 1.037*** (0.199)
0.745* (0.460)
CBI 0.397 (0.257)
-6.123*** (0.579)
Constant 3.245*** (0.428)
6.687*** (0.874)
R2: 0.348 0.914
R2: Ajusted 0.316 0.909
F(4,80) 10.680 211.600
Prob > F 0.000 0.000
(*) 15% significant, (*) 10% significant, (**) 5% significant and (***) 1% significant. Standard Deviations are in brackets.
4. Conclusion
Throughout this work, it has been analyzed to what extent the independence of
central banks in countries that adopted the Inflation Targeting System affects the level
of benchmark interest rate in a sample of nations. In the first section, it has been
presented some of the main arguments found in literature that deal with the CBI theme,
in which it was possible to identify that the principal issue is not whether these
institutions should have independence or not – since the benefits of this measure are
significant -, but which level of independence should be adopted.
In regard with the results estimated for the sample of countries with inflation
targeting system, based on a Taylor Rule modified, the results obtained suggest that the
22
countries which reconcile targets with central banks independence, on average, coexist
with lower benchmark interest rates. Cukierman (1992) demonstrated that the CBI in
developed countries has presented an inverse relation with the inflation level, while in
the sample of developing countries, this relation has not been found.
In the present work, the results point to an inverse direction, that is, the
developing countries with inflation targeting system which have independent central
banks present on average benchmark interest rates 6% lower to the ones found in the
other countries of the sample, whereas in developed countries, which also adopted the
inflation targeting system, the coefficient was not significant.
As it has been observed, the literature shows that it is important to evaluate the
CBI in developing countries considering the turnover , what consists in one of the
limitations of this work. The turnover index could help in the results, since the measure
used in this study concerns only about the legal situation of the central bank of each
country, which many times differs from the real degree of independence. Thus, future
works might be developed with the inclusion of the variable referred to, even though, as
it can be observed in literature, in general this one is only able to catch the CBI in
developing countries, what was obtained in the estimates accomplished even without its
presence.
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