Institutional checks and balances and the political control of the money supply

Abstract

The Nordhaus hypothesis about the political business cycle asserts that elected politicians have incentives to expand the money supply prior to elections to stimulate the economy and thereby engineer their reelection. Central bank independence is widely regarded as an institutional solution to this problem. However, this solution works only if central bankers are not perfect agents of their political principals, perhaps because they are conservative (more inflation-averse). This article proposes an alternative solution: political business cycles may be obstructed by institutional checks and balances. The analysis applies to the Deutsche Bundesbank and has implications for the institutional structure of the future European Central Bank. Copyright 1998 by Royal Economic Society.