Independence of the Central Bank

Abstract

We present a model in which the central bank, the current government and the median voter interact strategically and repeatedly. If the central bank is completely independent, it can implement an equilibrium in which the monetary policy is tight and beneficial in the long run. However, if the central bank has only some degree of operational autonomy, then a sufficiently impatient population may impose a bad equilibrium in which the government and the central bank coordinate their actions to run a loose economic policy that benefits the short run and is very costly on the long run in terms of inflation and unemployment.