A Third-Generation Framework: Reconsidering CBI and Fixed Exchange Rates

• In Event: Exchange Rates and Government Credibility Reconsidered

Abstract

This paper presents and develops a third-generation framework for understanding the political-economy of monetary institutions, focusing on central bank independence (CBI) and fixed exchange rates (FIX). The first-generation framework studied both institutions, but separately as potential solutions to the time-inconsistency problem related to monetary policy (i.e., inflation control). Bernhard, Broz, and Clark (2001) offered a second-generation framework to study CBI and FIX together but also with a focus on inflation control, asking if these two monetary institutions function more as complements or substitutes in achieving this macroeconomic objective. Consistent with the second-generation, our third-generation framework proposes that CBI and FIX should be studied together, but not as institutions that are both focused on inflation control. While we agree with the first- and second-generation frameworks regarding CBI being used as a solution for the time-inconsistency problem, we argue that FIX has been used primarily for a different and often contradictory (at least in the short-term) macroeconomic objective, namely exchange rate stability. Following this logic, CBI and FIX are neither complements nor substitutes in terms of inflation control. Instead, they are generally used for different macroeconomic objectives. And since both institutions implicate the same basic policy instrument, their use to achieve different macroeconomic goals should engender political battles over monetary policy between the actors that favor domestic price stability versus those that prefer external currency stability.

This new framework is developed in three steps. The first considers the primary substitution argument, advanced by Broz (2001) from the second-generation framework. Following the logic that inflation control requires transparency, which can either come from the political system (with democracies being more transparent) or from the monetary institution (with FIX being more transparent than CBI), Broz showed that 1) more democratic governments are less likely to fix their exchange rates, and 2) CBI can be associated with lower inflation but only in more democratic regimes. However, his substitution argument also proposed two other hypotheses that remain untested: 1) democracies are more likely to choose CBI, and 2) FIX can be associated with lower inflation, at least in less democratic political regimes (where more transparency is needed). Using expanded datasets on both CBI and FIX, we find only limited support for both of these two substitution hypotheses.

The second step considers some untested hypotheses about CBI and FIX as complements in terms of inflation control, also from the second-generation framework. Following the logic that both monetary institutions are imperfect, Bodea’s (2010) model proposes that 1) CBI and FIX should be positively associated with each other, and 2) governments adopting both monetary institutions should experience less inflation than those who adopt only one (either CBI or FIX). Our results show strong support for her first hypothesis, but no support for the second: governments that adopt CBI and FIX together do not achieve lower inflation. Indeed, central bank independence is often associated with less inflation control when accompanied by more fixed exchange rates.

Our third step is to present and test the macro(economic) foundations underlying our third-generation framework, which we argue better accounts for the many results discussed above. Assuming that an association between a monetary institution and a macroeconomic outcome (e.g., inflation control and exchange rate stability) exists because the former could be effective towards achieving the latter and it is actually being used for such, we provide evidence of a strong association between CBI and lower inflation (not surprisingly), but no such association between FIX (either on a de jure or de facto basis) and lower inflation. We also show evidence of a strong association between de jure fixity and external currency stability (not surprisingly), but no such association between CBI and external currency stability. These results can be interpreted as evidence that these two monetary institutions are generally being used for different macroeconomic objectives. We also show how these two macroeconomic objectives may be inconsistent at least in the short-term by demonstrating that inflation control requires a higher nominal interest rate (not surprisingly) but that exchange rate stability typically requires a lower nominal interest rate following the interest parity condition. This understanding has important political implications since both CBI and FIX involve the same basic policy instrument, but in a different direction, potentially creating a political battle between the actors who want more CBI for greater inflation control (consistent with domestic monetary policy autonomy) and those who want more FIX for greater external currency stability.

Authors

• David H. Bearce, University of Colorado, Boulder

• Ana Carolina Garriga, University of Essex