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EPRI Working Paper 2013-1
The search for a relationship between central bank laws and monetary policy outcomes, which began three decades ago, is part of a larger enterprise to discover the monetary policy framework that delivers the best macroeconomic performance. A 'monetary policy framework' is a set of institutional arrangements under which monetary policy decisions are made and executed. It includes central bank law and the degree of independence it gives the central bank. It also includes other formal and informal arrangements between the central bank, government, and other institutions. And it includes the custom and practice of the economists and decision-makers in the central bank and government. The 'best macroeconomic performance' that monetary policy can deliver remains controversial but a dispassionate and research-supported view is that it cannot influence the average level of output or unemployment and the best contribution it can make is to deliver low inflation at a point on the Taylor curve - the efficiency frontier between the variability of inflation and the output gap - consistent with the preferences expressed through the political process. Points above the Taylor curve are inefficient and points below it are unattainable. Within this broad research agenda, what has been discovered about the effects of central bank laws on monetary policy outcomes? Do central bank laws influence monetary policy and the inflation rate? Do independent central banks do the best job? What other features of the monetary policy framework matter for achieving low inflation and low variability? Does inflation targeting beat central bank independence as a source of good macroeconomic performance? What follows is an attempt to answer these questions. Part I provides an overview of work that has measured central bank independence and looked for a (negative) relationship between independence and inflation or independence and other variables. Part II examines the main criticisms of this work and provides a new and expanded evaluation. Part III presents two natural experiments made possible by events over that past three decades that shed new light on the questions posed above. And Part IV offers some speculative thoughts about changing constraints on central banks that might challenge their independence and influence. By way of brief preview, I will argue that most of the search for a relationship between central bank independence and inflation has found only modest additions to what we knew thirty years ago. But two natural experiments suggest that more independent central banks lower the variability of inflation and might lower average inflation, with no change in the variability of output; and inflation-targeting central banks lower inflation and might lower the variability of both inflation and real GDP growth regardless of the independence of the central bank.
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