The benefits of central bank's political independence

Abstract

We consider a two-tier model of monetary policy where the central banker is both subject to the explicit in uence of elected political principals through contracts and the implicit in uence of interest groups willing to capture monetary policy. We analyze the impact of granting independence to the central banker on the scope for capture and the agency costs of delegating the monetary policy to a central banker. Political independence increases those agency costs but signiÿcantly stabilizes the politically induced uctuations of in ation and improves ex ante social welfare.

Regulatory capture and banking supervision reform

“…2 Indeed, capture has already been a concern during the Savings & Loans debacle (see Kane, 1990aKane, ,b, 2001, and in past regulatory debates 2 In an article in Bloomberg we read "With power from Congress to oversee the previously unregulated $615 trillion market for over-the-counter derivatives, it [the Commodity Futures Trading Commission] has become one of the hottest lobbying spots in town." ("Wall Street Lobbyists Besiege CFTC to Shape Derivatives Rules", October 14, 2010). in the United States and in Europe (see, for instance, Abrams and Settle, 1993;Benink and Schmidt, 2004;Gabillon and Martimort, 2004;Heinemann and Schüler, 2004).…”

Monetary Policy Capture and Political Stabilization

“…Following Gabillon and Martimort (2004), we now write social welfare, in regime political control with party…”

“…All these aspects have been analysed by Gabillon and Martimort (2004), who consider a "two-tier" model of monetary policy where the Central Banker is subject to both explicit influence by the elected political principal through a contract and implicit influence by anti-inflation interest groups seeking to "capture" monetary policy. The degree of political independence therefore influences the agency costs paid to control the Central Banker.…”

“…The degree of political independence therefore influences the agency costs paid to control the Central Banker. The result obtained by Gabillon and Martimort (2004) is that political independence increases the agency costs (agency cost effects) but prevents greater fluctuations in inflation due to exogenous political uncertainty with respect to the election result (stabilization effect). On comparing the two effects, ex-ante social welfare increases in the case of political independence.…”

“…Section 2 presents a summary of Gabillon and Martimort"s model; Section 3 describes our extension of this model; finally, Section 4 sets out the conclusions. Gabillon and Martimort (2004) provide an explanation for a possible link between the degree of independence of a Central Bank (CB) and policy stabilization. The first key ingredient of the model is the possibility of capture of these agencies by the interest groups in the financial sector.…”