Economics Letters 84 (2004) 305 309

www.elsevier.com/locate/econbase

Does central bank independence lower inflation?

Mustafa Ismihan a, F. Gulcin Ozkan b,c,*
a

Department of Economics, Atilim University, Ankara, Turkey

b
University of York, UK
c
CEPR, UK
Received 7 August 2003; accepted 19 December 2003
Available online 19 May 2004

Abstract
This paper provides a potential explanation for the recent findings of no significant relationship between central
bank independence (CBI) and lower inflation. We argue that although CBI delivers lower inflation in the shortterm, it may reduce the scope for productivity enhancing public investment and so harm future growth potential.
We also argue that the effects on growth make CBI less likely to achieve lower inflation in the long-term.
D 2004 Elsevier B.V. All rights reserved.
Keywords: Central bank independence; Public investment; Inflation
JEL classification: E58; E62

1. Introduction
Following the pioneering work by Rogoff (1985), the delegation of monetary policy making powers
to independent central banks (CB) has been widely believed to bring about lower inflation. Since then, a
number of studies have provided empirical support for this negative relationship between CB
independence (CBI) and inflation for various samples of industrial democracies (e.g., Alesina and
Summers, 1993). However, empirical evidence from developing countries has been less clear-cut.
Furthermore, several recent studies have shed doubt on the robustness of the existing findings even for
higher income countries (e.g., Campillo and Miron, 1997; Forder, 1998; King and Ma, 2001).

* Corresponding author. Department of Economics, University of York, Heslington, York YO10 5DD, UK. Tel.: +44-1904434673; fax: +44-1904-433759.
E-mail address: fgo2@york.ac.uk (F. Gulcin Ozkan).
0165-1765/$ - see front matter D 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.econlet.2003.12.022

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M. Ismihan, F. Gulcin Ozkan / Economics Letters 84 (2004) 305309

This paper argues that there may be good reasons why CBI may not reduce inflation in some
countries. We develop a framework in which public investment can enhance the future growth potential
of an economy and analyze the impact of CBI on the composition of public spending. Using this
framework, we argue that CBI reduces the scope of public investmentby lowering the available
finance through lower inflation in the short-termand this leads to a worsened output performance for
the economy in the long-term. In turn, this may worsen the long-term inflation performance generating
either no or a positive observed relationship between CBI and inflation.

2. The basic model

We utilize a simple two-period model of discretionary policy making. The policy making framework
is such that government acting through the fiscal authority chooses taxes and spending while monetary
policy decisions are made by an independent CB.
To explore the implications of the governments strategic decision regarding the composition of public
expenditure, we distinguish between public sector consumption ( gc) and investment ( gi). Public
investment consists of productivity enhancing expenditure on, e.g., infrastructure, health and education.
However, as these favorable consequences are not realized until future periods, this type of spending
does not form part of the policy makers current utility function. On the contrary, public consumption is
made up of public sector wages, current public spending on goods, and other government spending that
is assumed to yield immediate utility to the government. These factors suggest that the fiscal authoritys
disutility function can be represented in the following form:
LG
t

2
1X
bt1 d1 p2t xt  xt 2 d2 gtc  g ct 2 
2 t1 G

where LGt denotes the welfare losses incurred by the government, pt is inflation rate, xt and xt are the (log
of) actual and desired levels of output, gct and gtc are the actual and desired public consumption as shares
of output, d1 and d2 represent the governments aversion to deviations of inflation and public spending
from their respective targets, respectively, and bG is the governments discount factor. Target inflation is
taken to be zero to indicate the desirability of price stability.
Similarly, the preferences of the CB can be described as:

LCB
t

2
1X
2
2
bt1
CB l1 pt xt  xt 
2 t1

where LCB
t denotes the welfare losses incurred by the CB, l1 is the CBs inflation stability weight, bCB is
the CBs discount factor and the independent CB is more conservative than the elected government;
l1 > d1 and it does not discount the future at as a high rate as the elected government; bCB>bG (CCB will
henceforth refer to this conservative central banker). In addition, because public consumption spending
impacts upon the welfare of the elected government as opposed to the CB, no terms relating to gc enter
the CBs loss function.

M. Ismihan, F. Gulcin Ozkan / Economics Letters 84 (2004) 305309

307

Now, consider a representative competitive firm facing the following production function: Yt = AtNtc,
where Yt, Nt and At represent output, labor and the level of productivity in period t, and 0 < c < 1. The
representative firms problem is to maximize profits Pt(1  st)AtNtc  WtNt, where Pt is the price level,
Wt is the wage rate and st is the tax rate on the total revenue of the firm in period t. The representative
firm chooses labor to maximize profits by taking Pt, Wt and st as given. The resulting output supply
function, utilizing wt = pet, where superscripts e denote expectation, is yt = a(pt + 1/c at-pet-st) + aln(c)
where pet is expected inflation, a = c/(1-c) and ln(1-s) is approximated by  s (lower case letters
represent logs).
Productivity enhancing role of public investment is formalized as at = a0 + fgti  1, where f>0.
Substituting at into the previous equation and normalizing output by subtracting the constant term
aln(c) + aa0/c from yt yield the following normalized output supply function:
i
 pet  st
xt apt wgt1

where w = f/c. The government budget constraint creates the link between the fiscal and monetary
policies, which is formally given by
gtc gti pt st

To abstract from issues of debt dynamics, we exclude borrowing as a source of finance.1 Thus,
seigniorage and taxes are the two alternative ways of financing the two types of public expenditure.
2.1. Features of the equilibrium
The equilibrium outcome is found by using backwards induction. A subset of solutions regarding
inflation and public spending under both (i) the centralized structure (where government is the only
authority actively designing both the fiscal and monetary policies) and (ii) the decentralized one (where
monetary policy making is in the hands of a CCB) is provided in Table 1.
Some of the important comparisons regarding the implications of CBI, as presented in Table 1, are
formalized by the following propositions.
Proposition 1. Delegating monetary policy making powers to an independent CCB leads to lower
inflation in t = 1. This, in turn, reduces the available resources for public spending thereby leading to a
fall in public investment. That is, p1CCB < p1G which leads to g1i,CCB < g 1i,G.
Proof 1. For p1CCB < p1G to hold, (KVHV/l1) should be smaller than (2KH/d1). For this condition to hold,
in turn, l1 should be greater than y1/2. Given that the CB is more conservative than the elected
government, l1>d1, this condition is guaranteed and thus p1CCB<k1G. Similarly, for g1i,CCB to be smaller
than g1i,G, both HV>H and HVCV< HC should hold. The requirement for both of these conditions is again for
5
l1 to be greater than y1/2. Thus, g1i,CCB < g1i,G.
1

Ismihan and Ozkan (2003) incorporate public borrowing as a third source of financing public expenditure within this
framework. It is shown that, in that case, the composition of public spending is also determined by the benefits of public
investment relative to the cost of public borrowing.

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M. Ismihan, F. Gulcin Ozkan / Economics Letters 84 (2004) 305309

Table 1
Equilibrium macroeconomic outcome
CCB
=(d2kV/l1)[x2/a + g2c-wgi,CCB
]
pCCB
2
1
i,CCB
g1
= HV[  g 1c + CVg2c  (1/a)x1+(CV/a)x2]
pCCB
=(d2/l1)[KVHV(wg1c + g2c+(w/a)x1+(1/a)x2)]
1
Centralized
c
i,G
pG
2/a + g2  wg1 ]
2 =(2d2k/d1)[x
i,G
c
c
g1 = H[  g1 + Cg2  (1/a)x1+(C/a)x2]
c
c
pG
1 + g2+(w/a)x1+(1/a)x2)]
1 = 2d2/d1[KH(wg
Superscript G is used for the centralized outcome where G is used to denote the government as opposed to the outcome under
CCB and
1
2d2 2
1
d2 2d2
; C 1 /K; K wbG D; D
; / 2
k k; k
;
H
1 wC
1 /
d1
a
d1
1
wbG
a2 d1 d2 d2 l21 a2 l21 2
1
; CV
and
D V; KV wbG D V; D V
k V ; kV
HV
1 wCV
1 /V
kV
a2 l21
d2 d2
/V 2 :
a
l1

It is also evident from Table 1 that the higher is public investment in t = 1, the lower will be the
inflation bias in t = 2. This is due to the favorable effect of higher public investment committed in t = 1 on
output and public spending in t = 2. This suggests that CBI may have potentially harmful effects on the
productive capacity of an economy by reducing the scope for productive public investment which, in
turn, worsens the inflationary performance in the following period. These arguments are formalized in
Proposition 2.
Proposition 2. The equilibrium level of inflation in t = 2 is unambiguously lower under a CCB iff public
spending has no productivity enhancing role; w = 0. When w>0, an independent CCB may bring about a
worse inflation performance in t = 2.
Proof 2. When w = 0, for p2CCB to be smaller than p2G the following (kV/l1) < (2k/d1) should hold. This, in
turn, requires, as above, l1 > d21. The fact that l1>d1 thus establishes p2CCB < p2G when w = 0. In the case of
w>0, the following condition; (kV/l1) g1i,CCB>(2k/d1) g1i,G also needs to be satisfied for p2CCB<k2G to hold.
5
Proposition 1 established that g1i,CCB<g1i,G; therefore, p2CCB is not necessarily smaller than p2G.
In summary, given the productivity enhancing role of public investment, independent CBs may not
deliver better inflation performance in the long-term. Whether this will indeed be the case is determined
by whether the CBIs favorable credibility effect in t = 2 is smaller than the unfavorable effect in t = 2 of
lost public investment in t = 1.
Proposition 3. Delegating monetary policy making powers to independent CBs lowers
average inflation
CCB
G
2
when
unambiguously only if public spending has no productivity effect; that is, p1 p22 < p1 p
2
w = 0. When w>0, CBI may produce higher inflation on average.

M. Ismihan, F. Gulcin Ozkan / Economics Letters 84 (2004) 305309

Proof 3. Follows from Propositions 1 and 2.

309

The above analysis suggests that the productivity of public investment (w) plays a crucial role in
determining whether CBI delivers lower inflation in the long-term. w, in turn, may be related to factors
such as the quality of investment spending. Corruption in the public sector, for example, may
significantly influence the overall productivity of public investments. w also depends on the level of
development of a given country. It is frequently argued that the returns from infrastructure spending are
expected to be higher in developing countries (see, e.g., World Bank, 1994). Cross-country differences in
w, thus, may have a potential explanatory power for empirical analyses of the relation between CBI and
average inflation performance.

3. Conclusion
This paper has shown that, in countries where inflationary finance is important and the productivity of
public investment is high, delegating monetary policy making to an independent CB may harm inflation
performance in the long term. This is because lower contemporaneous inflation produced by an
independent CB reduces the financing available for public investment, which unfavorably impacts on the
productive capacity of an economy, and hence the scope for inflation reduction in future. Our results may
provide a potential explanation for empirical findings of positive or no significant relationship between
CBI and average inflation especially in developing countries.
Acknowledgements
We are grateful for useful comments from participants at MMF Conference and seminars at the
University of Cambridge and the University of Birmingham. We would like to thank the ESRC for
research support under the Understanding the Evolving Macroeconomy Program (Grant L138251026).

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