To be or not to be? Central bank independence and economic turmoil

Abstract

A few years ago, many economists believed that high inflation was over and the issue of central bank independence seemed out-of-date. In light of response to COVID-19, inflation has returned, reviving the monetary autonomy debate. This paper proposes a model that sheds light on establishing central bank independence in the presence of economic shocks. We show that high rent from holding office, often related to corruption, leads to a lack of monetary autonomy, whereas the central bank is more likely to be independent when the future payoffs are less valuable, there is greater economic volatility, output is highly valuable in voter preferences, a big proportion of output economic shocks is passed onto inflation, or there is a greater variability in political competence. We also derive optimality conditions for each equilibrium. We find that equilibria with an independent central bank are always optimal and the lack of central bank independence cannot be optimal when almost all politicians are competent, all politicians are of similar quality, or output is highly valued in voter preferences.