Central Bank Independence - A Deeper View

Central bank independence - a deeper view
from P.De Grauwe, The Economics of Monetary Integration , Oxford University Press
from P.De () Grauwe, The Economics 1 / 18
Central bank (CB) minimizes loss of welfare from deviation of unemployment u and ination from target values u , L = ( Note that
( 0): weight attached to unemployment relative to ination (the higher is , the more the CB cares about u rel. to or vice versa, the relative weight it assigns to is lower) u is assumed to be smaller than un , the natural rate of unemployment.
)2 + (u
u )2
For simplicity, we shall take u , = 0, so that L = 2 + u2 (1)
The function L in (1) gives rise to a map of indierence curves, represented in Fig. 1.a Notice that
indierence curves closer to the origin correspond to lower loss of welfare / they are preferred to those farther away from origin; they are negatively sloped in the (u, ) plane; they are concave (if u is already very high, to accept a given increase of it you need a higher fall in than when you start with a lower u) they are atter the lower is (see Fig. 1.b) if = 0, indierence curves are horizontal.
CB controls . It doesn t simply set = 0 because the lower is , the higher u will be there is a trade-o between these two variables, captured by the Expectation augmented Phillips Curve: = e (u un )
The above equation implies that only unanticipated ination aects unemployment. Why? Your Macro course taught you why... For simplicity, set = 1, so that = e
(u
un )
(2)
(2) is represented graphically, for a generic e , in Figure 2.
CB maximizes (1) subject to (2) ) it will set at the value that corresponds to the tangency bet. (2) and an indierence curve . Assume we live in a rational expectation world, where CB follows a discretionary policy it sets the ination rate optimally each period, given the prevailing expectations. Say CB announces = 0, and that individuals believe this announcement, so that they start expecting zero ination, e = 0. The Phillips curve corresponding to this case is the straight, downward sloping line in Fig. 3
So, if CB announces that it will set = 0, the public believes this announcement, and the CB actualy sets = 0, then we end up at point 1, with u = un . But: will the CB set = 0? NO, because, as soon as e = 0, setting = 2 > 0 will allow it to reach point 2, on a lower indierence curve. In words, it has an incentive to generate surprise ination, that will yield an unemployment rate lower than un Will the CB necessarily cheat? Not necessarily, since the extra ination we have at 2 will lead individuals to revise their expectations of ination upwards ) the Phillips curve will shift upwards, and - for any given u there will be more ination next period
So, CB has to evaluate short-term gains from cheating against the future losses caused by the adjustment of expectations Say it is short-sighted ) it cheats today, and we go to point 2 However, individuals will start expecting more ination, the Phillips curve shifts upwards, and we go to point 3, where is optimal for the CB to raise ination above 2 , to 3 But at 3 the same process repeats itself, till the economy reaches N
at N, u = un , so that = e CB has no longer any incentive to surprise agents with more ination
Point N is the rational expectations equilibrium under a discretionary policy (i.e., when CB sets the ination rate optimally each period, given the prevailing expectations) The policy rule of zero ination, and the associated point 1, are time inconsistent So, under discretion, we end up in an equilibrium (N) in which u = un and > 0. By how much? In equilibrium, is going to be higher
the higher is that is, the higher the weight attached to unemployment rel. to in. , and therefore the steeper the indierence curves (see Fig. 4) [graphically, a high implies a steeper expansion path the line connecting poits 2, 3 ... N in Fig.3, leading to an equilibrium with higher ] the higher the natural rate of unemployment, un (see Fig. 5)
At equilibrium N, ination higher than target rate (here, = 0). How can society make come closer to target? One possibility is to appoint a "conservative" central banker, one attaching to u a lower weight than society. Implicitly, this means that he cares a lot about ination - is low, and we end up at an equilibrium N with lower ination. In the limit, if = 0, indierence curves are horizontal and equilibrium N coincides with 1 But why would a central banker ever want to move the economy at a level below un , unless he has a very short horizon? Push to move u below un may come from Government (politicians are notoriously short-sighted), not directly from CB Then, a conservative, independent CB will be insulated from Government intervention, will not seek to push u below un , and therefore will not suer from high ination even under discretionary policy. The above reasoning, especially as far as CB independence is concerned, is implicit in the Maastricht Treaty.
The design of ECB Consider the above model with 3 countries, Germany, France and Italy. Assume that they are identical, except for the preferences their authorities attach to combating ination and unemployment. Germany attach a weight to reducing ination higher than France, and France higher than Italy. ) Germany has indierence curves atter than France, and France atter than Italy ) equilibria in the three countries in Fig. 6, with Germany having the lowest in. rate, Italy the highest. In a monetary union, the ECB s behavior will reect the preferences of those countries that are member of the union, and the outcome will depend on the size of the union. If only Germany and France join the union, equilibrium will be between points A and B, say point E. Union will be attractive to Germany if gains of the union (elimination of transaction costs, less uncertainty due to exchange rate uctuations, etc.>) will outweigh loss in welfare due to highr ination. If also Italy joins, equilibrium is at a point like F, loss of welfare for Germany is higher, and e ciency gains from union must be correspondingly higher.
Problem is that, in joining the union, there is nothing to be gained for the low-ination country in terms of ination and unemployment. All the gains are for the high ination country So, the only way for the low-ination country to agree to move to a monetary union is to design a (common) ECB as hard-nosedabout ination as the low-ination country s own CB. Failure to design the common CB this way could lead to a situation where the low-ination country refuses to take the nal step to the monetary union. However, situation is even worse. Say that ECB has the same preferences as the German CB, but that there are structural dirences in the union. In particular, assume that average un in the union is higher than German un . We know (see Fig. 5 above) that, even if ECB is as hard-nosed as German CB, we are going to have an ination rate in the union higher than the the one would have prevailed in a Germany outside of the union [notice than on average, in the 80 s and 90 s u in germany was lower than in the rest of Europe] Only way out: to have a ECB that gives an ever higher weight to price stability than the German CB did in the past.
It is not so surprising, given the above discussion, that

the Treaties explicitly declare that the primary objective of the European monetary policy is price stability (in this primary goal, no reference to high employment) the ECB has been made institutionally independent of the political authorities (including the European Commission and the European Parliament)
As a matter of fact, political independence of the ECB is greater than the one that was enjoyed by German CB a simple majority of the German parliament could change the statute of the latter, while changes in the statute of the ECB need changes in the Treaties, a very complex aair.

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