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Flexible majority rules for central banks.

Article Excerpt
THIS PAPER PROPOSES a flexible majority rule for central banks. The flexible majority rule works as follows: within a prespecified time frame, the size of the majority necessary for adopting an interest-rate change depends on the size of the interest-rate change itself. For small changes in the interest rate, only a small share of the votes is required. For large interest-rate changes, a larger majority is necessary, tending toward unanimity.

We consider a model where N central bankers, representing countries, regions, or different constituencies within a country, decide on monetary policy. The central bank loss function is composed of the weighted loss functions of countries, regions, or constituencies. This is the typical case for the European Central Bank (ECB) but also applies to the Federal Reserve. In our example, we consider the ECB when the monetary union is hit by a shock dividing the union into two parts. After this shock, one part desires a change in monetary policy, while the other part wants to retain the status quo. For instance, some countries may be affected negatively by a supply or demand shock, and concern for their own country's welfare makes them want to ease monetary policy through interest-rate cuts. Other countries, not affected by the shock, will prefer no change in the interest rate. Under simple majority rule, a change in interest rate will occur if and only if a simple majority desires a change. Under flexible majority rule, small changes in the interest rate will only require a small share of supporting votes and hence a small number of countries to agree, whereas large changes in the interest rate require large majorities.

The key advantage of the flexible rule is that a number of countries hit by negative shocks can partially ease the consequences by a small interest-rate cut. Larger changes in the interest rate, however, require larger majorities, which can only be achieved if a larger number of countries is affected by the shock. The flexible majority rule represents a compromise between the countries affected by the shock and the other countries. The drawbacks of simple majority rules and unanimity rules (possible exploitation of minorities, unanimity rules creating extreme veto power) can be overcome by flexible majority rules.

We compare the simple majority rule with the flexible majority rule. Our main result is that the flexible majority rule leads to lower social losses than the simple majority rule. Welfare-enhancing flexible majority rules enable minorities or small majorities--either a few large countries or a number of small countries--to bring about small interest rate changes. For large interest-rate changes a large fraction of supporting votes is required. The main intuition for our results is that flexible majority rules of the kind described above can approximate aggregate social loss minimization, which calls for small interest-rate changes when shocks are small and affect only a few countries and large interest-rate changes when shocks are larger and affect many countries. In the last section of this paper, we discuss conceptual and practical issues of our proposal.

1. RELATION TO THE LITERATURE

1.1 Regional Bias in Central Bank Decisions

A socially desirable procedure for making decisions in central bank committees has been the focus of a substantial body of recent literature.

Three areas have been investigated. The debate about optimal institutional design of the ECB had focused on its degree of centralization. Von Hagen and Stippel (1994), Lohmann (1997), and Bindseil (2001) have highlighted the advantages of a stronger role for the centrally nominated ECB. (1) Berger (2006) suggests several ways of improving the organization of the ECB Governing Board. We suggest that flexible majority rules may partially function as a substitute for lack of centralization at the ECB....

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