Central Bank independence: Low inflation at no cost? A numerical simulations exercise

Abstract

The independent nature of the Central Bank is often associated with achieving low and stable inflation. Further to that the merits of independence are stretched to achieving low(er) output variability when compared to a government run monetary policy. In this paper we use the Alesina (1989) and Alesina and Gatti (1995) model to examine how often an Independent Central Bank can achieve an improvement on both counts. To do that we run numerical simulations where we change the ex ante probability of elections (and hence the degree of electoral uncertainty) with a view to determining how the private sector’s perceptions affect the level of output variability. Our conclusions agree with the Alesina and Gatti assertion that there will exist occasions when all political parties will be better off by consenting to the running of monetary policy by an independent institution but more often than not this comes at some cost to output. On theoretical grounds therefore, the trade-off between inflation and output variability (à la Rogoff) is still a valid one.