Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague JEM027 Monetary Economics Central bank‘s independence, transparency and accountability Tomáš Holub November 23, 2015 Partly based on presentation of K. Šmídková from the previous year

JEM027 – Monetary Economics 1 Best practice for central bank institutional design ▪ What is the best practice, if you want to establish a „good“ central bank? ▪ How did we arrive to this best practice ? ▪ What does the economic literature tell us about the optimal institutional design? ▪ Does good institutional design lead to better actual performance? ▪ Seminar topic: how to measure CB independence and transparency?

JEM027 – Monetary Economics 2 Best practices for institutional framework ▪ Framework should consist of three pillars – Independence – Accountability – Transparency ▪ Each has specific, but inter-related roles – Prevent inflation surprises, anchor inflation expectations – Avoid the „inflation-freaks“ problem and deflation surprises, reduce the democratic legitimacy deficit – Anchor expectations, increase efficiency of transmission, reduce the democratic deficit

JEM027 – Monetary Economics 3 Four players in the framework Parliament Central bank PublicGovernment Central bank interacts with three players within the institutional framework

JEM027 – Monetary Economics 4 Central bank and government No dependence Parliament Central bank Public Government Government: should not intervene (no inflation surprises)

JEM027 – Monetary Economics 5 Central bank and parliament Independence Accountability No dependence Parliament Central bank Public Government Parliament grants independence to central bank and it holds central bank accountable (no „inflation-freaks“)

JEM027 – Monetary Economics 6 Central bank and public Independence Accountability No dependence Parliament Central bank PublicGovernment Transparency Public should have all information (to anchor expectations and make transmission efficient)

JEM027 – Monetary Economics 7 Current practice: product of high inflation ▪ Previous approach to monetary policy led to suboptimal outcomes ▪ Problems – Hyperinflations (South America; some post-communist countries) – High inflation in advanced countries (1970’s to early-1980’s)

JEM027 – Monetary Economics 8 Increasing central bank independence Source: Arnone M et al "Central Bank Autonomy: Lessons from Global Trends," IMF Working Papers 07/88, International Monetary Fund.

JEM027 – Monetary Economics 9 Convergence in central bank independence Source: Walsh (2007)

JEM027 – Monetary Economics 10 JEM027 – Monetary Economics Increasing central bank transparency Source:

JEM027 – Monetary Economics 11 JEM027 – Monetary Economics Independence and accountability in theory ▪ Kydland, Prescott (1977): „Discretionary policy … will not typically result in the social objective function being maximized.“– strong argument for rule-based policy ▪ Barro, Gordon (1983): show that if central bank has the same loss function as government, economic agents will expect inflation surprises – strong argument for independence ▪ Rogoff (1985): shows that conservative (i.e. independent and inflation-averse) central bank can reduce these inflation surprises and anchor inflation expectations ▪ Walsh (1995): the central banker should have an adequate contract with the public to avoid inflation surprises fully, and at the same time achieve an optimal response to shocks

JEM027 – Monetary Economics 12 JEM027 – Monetary Economics Political-economy argument for independence ▪ Short-term political motivations may not be conducive for achievement of long-run monetary policy goals; ▪ Kydland, Prescott (1977); Barro, Gordon (1983); ▪ Politicians try to fool people (promise low inflation, but later on inflate to increase seigniorage and employment); ▪ Reasons: misusing short-term benefits, costs visible in the long run only; pretending good supply-side policies; focusing on unemployed as a “swing-voter” group; ▪ But people sooner or later recognize this and incorporate it into their expectations  inflationary bias; ▪ No positive benefits in terms of higher long-term employment; ▪ Rule-based policy can thus be better than discretions.

JEM027 – Monetary Economics 13 JEM027 – Monetary Economics Dynamic inconsistency – graphical illustration ▪ With zero inflation expectations, B is better than A; ▪ But B is not a long-run equilibrium: inflation accelerates and expectations shift upwards; ▪ Eventual outcome is E, i.e. much worse than A; ▪ Optimal policy leads to sub-optimal outcome.

JEM027 – Monetary Economics 14 JEM027 – Monetary Economics Barro-Gordon model … where ▪ y* is long-run equilibrium output (absence of shocks) ▪ π E is expected inflation ▪ z t is supply shock (e.g. oil prices) ▪ ε t is technology shock (short-run equilibrium: y*+ε) ▪ a is slope of the Phillips curve (assumed to be 1) Expectations are rationale Output equation (Phillips curve)

JEM027 – Monetary Economics 15 JEM027 – Monetary Economics Barro-Gordon model: government Loss function of the government (two targets) Government policy: to achieve higher than equilibrium output (k is positive) Assumption for targeted output … where ▪ y** is long-term targeted output ▪ χ [chi] determines the (relative) importance of inflation target

JEM027 – Monetary Economics 16 JEM027 – Monetary Economics Barro-Gordon model: central bank Monetary policy in the model: central bank directly controls inflation (i.e. minimizes loss function wrt. inflation) Central bank is not independent, it has the same loss function as the government Loss function (after substitution)

JEM027 – Monetary Economics 17 JEM027 – Monetary Economics Barro-Gordon model: optimization Outcome of the optimization Expected inflation by agents is equal to expected reaction Optimization

JEM027 – Monetary Economics 18 JEM027 – Monetary Economics Barro-Gordon model: conclusions ▪ If the central bank is not independent (it follows the government policy), we have an inflationary bias On average inflation is not zero (by substitution) Expected inflation is not zero

JEM027 – Monetary Economics 19 JEM027 – Monetary Economics Barro-Gordon model: graphical illustration ▪ In equilibrium: inflation equals to expectations on average (z is zero on average) ▪ In equilibrium: inflation is above optimum (i.e. zero) ▪ This is a self- fulfilling credibility problem. π πEπE Slope: 1/(1+χ) k/(1+χ) k/χ E Target

JEM027 – Monetary Economics 20 JEM027 – Monetary Economics Possible solutions in the literature ▪ Reputation – Can it really work if the central bank is under political control (short election cycle)? ▪ Fixed exchange rate – Soft pegs vulnerable to self-fulfilling attacks; Hard pegs very rigid (no response to supply-side shocks) ▪ Delegation to conservative central banker – Rogoff (1985); BuBa usually given as an example; lower inflation, but less stable real economy (inflation freaks) ▪ Optimal contract with central banker – Walsh (1995); RBNZ often given as an example; but the optimal contract rewards deflation – couldn‘t it go too far?

JEM027 – Monetary Economics 21 JEM027 – Monetary Economics Fixed exchange rate as a policy rule ▪ A soft peg can lead to lower inflation (point 3), but at the cost of: (i) inability to react to shocks in normal times (the peg is adjustable only if shocks are large); (ii) risk of self-fulfilling currency crisis (Obstfeld, 1996); ▪ Hard pegs are more robust, but very rigid – no response to shocks at all.

JEM027 – Monetary Economics 22 JEM027 – Monetary Economics Rogoff: conservative central banker More emphasis put on inflation target (wrt. to targeted output) The appointed central banker is conservative“, i.e.: Central bank is independent and decides according to its own loss function

JEM027 – Monetary Economics 23 JEM027 – Monetary Economics Rogoff: conclusions Very conservative banker (high χ CB ): inflation close to zero, but also weak response to supply-side shocks (i.e. these shocks feed less into inflation and more into output) Expected inflation is lower than in the “not independent bank” case On average inflation is also smaller

JEM027 – Monetary Economics 24 JEM027 – Monetary Economics From Barro to Rogoff: graphical illustration ▪ In equilibrium: inflation equals to expectations ▪ In equilibrium: inflation is closer to optimum (i.e. zero) ▪ The real economy becomes more volatile π πEπE Slope: 1/(1+χ CB ) k/(1+χ CB ) k/χ CB E Target

JEM027 – Monetary Economics 25 JEM027 – Monetary Economics Walsh: optimal contract for central banker Central bank decides according to the same loss function as government Hence, the total central banker’s loss is However, there is a wage contract between the central banker and public (remember we put a=1)

JEM027 – Monetary Economics 26 JEM027 – Monetary Economics Walsh: central bank Loss function (after substitution) Optimization Central banker reaction function Note: k disappears

JEM027 – Monetary Economics 27 JEM027 – Monetary Economics Walsh: conclusions Expected inflation is zero On average inflation is zero, the response to shocks is optimal ▪ The properly defined wage contract removes inflation bias fully ▪ Recall: one must know a (=slope of the Phillips curve) to define the contract, and to be sure that the central banker has the same loss function as the gov‘t – in practice not easy

JEM027 – Monetary Economics 28 JEM027 – Monetary Economics From Barro to Walsh: graphical illustration ▪ In equilibrium: inflation equals to expectations ▪ In equilibrium: inflation is zero on average ▪ Real economy does not become more volatile π πEπE Slope: 1/(1+χ) E Target

JEM027 – Monetary Economics 29 JEM027 – Monetary Economics Remarks on accountability ▪ Accountability matters: contract suggested by Walsh (1995) prevents inflation surprises fully ▪ Example from practice: RBNZ in 1990’s ▪ BUT deflation pays off (!)... moral hazard issue ▪ Accountability is needed to ensure that the target of a central banker and the one of a central bank are the same ▪ In practice, central banks are held accountable by more complex procedures than the Walsh-type of the contract

JEM027 – Monetary Economics 30 JEM027 – Monetary Economics Does independence help to keep inflation low? Average inflation: Source: Alesina, A. Summers, L., Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence, Journal of Money, Credit and Banking, N°25, 1993.

JEM027 – Monetary Economics 31 JEM027 – Monetary Economics Does independence help to keep inflation low? Source: Walsh (2007) But: Once you control for a country‘s average inflation in the earlier period, any impact of central bank reform disappears.

JEM027 – Monetary Economics 32 JEM027 – Monetary Economics Summary ▪ If a central bank is sub-ordinated to the government, it is tempted to generate inflationary surprises. ▪ This feeds into people‘s expectations and generates a self-fulfilling credibility problem (inflationary bias). ▪ Solution: central banks independence, counter-balanced by clear monetary policy rules, transparency and accountability. ▪ The debate has shifted from rules vs. discretion to rigid vs. flexible rules. ▪ Fixed ER: preference of hard pegs (rigid rules) due to danger of self-fulfilling crises ▪ Autonomous MP: preference of flexible rules (e.g. inflation targeting – subject of the next lecture).

JEM027 – Monetary Economics 33 JEM027 – Monetary Economics Selected references ▪ Barro, Gordon ”Rules, Discretion and Reputation in a Model of Monetary Policy,” JME. ▪ Rogoff, Kenneth ”The Optimal Degree of Commitment to an Intermediate Monetary Target,” The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages ▪ Alesina, A. Summers, L ”Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking, N°25. ▪ Walsh, Carl ”Optimal Contracts for Central Bankers,” American Economic Review, 85, ▪ Obstfeld, M “Models of Currency Crises with Self-fulfilling Features,” European Economic Review, vol. 40 (April), pp ▪ Cihak, Holub ”The Economic Theory of Central Bank Independence,” The Czech Journal of Finance and Credit, 49. ▪ Mahadeva L., Sterne G ”Monetary policy framework in a global context,” Routledge, London. ▪ Geraats P. M ”Why adopt transparency? The publication of central bank forecasts,” ECB Working Paper No. 41 ▪ Frederic S. Mishkin ”Can Central Bank Transparency Go Too Far?,” NBER Working Papers 10829, National Bureau of Economic Research, Inc. ▪ Alex Cukierman ”The limits of transparency,” Proceedings, Federal Reserve Bank of San Francisco. ▪ Arnone M et al ”Central Bank Autonomy: Lessons from Global Trends,” IMF Working Papers 07/88, International Monetary Fund. ▪ Walsh Infl‡ation Targeting and the Role of Real Objectives.“ ▪ Geraats P. M ”Trends in Monetary Policy Transparency,” CESifo Working Paper Series 2584, CESifo Group Munich. ▪ Dincer and Eichengreen Central Bank Transparency and Independence: Updates and New Measures, BOK Working Paper No ( )