Publication: International Advances in Economic Research
Publication Date: 01-AUG-06
Delivery: Immediate Online Access
Author: Diana, Giuseppe ; Sidiropoulos, Moise
Article Excerpt
Abstract
Recent empirical contributions demonstrate that countries with less independent central banks enjoy lower output losses during disinflationary cycles. To explain these somewhat surprising empirical findings, some authors suggest that independent central banks probably face a flatter short-run Phillips curve. In this paper, we provide both theoretical and empirical arguments to rationalize this intuition. We demonstrate that, since central bank independence reduces the mean inflation rate and its variance, wage setters opt for a lower degree of nominal wage indexation leading to more wage and price inertia and, thus, to a flatter short-run Phillips curve. Consequently, this paper put forward a channel of positive influence of central bank independence on the sacrifice ratio through its impact on nominal wage indexation. Empirical tests, performed using a sample of 19 OECD countries during the 1960-1990 period, show that these theoretical results hold also empirically. (JEL E52, E58)
Introduction
A broad consensus have rallied around the idea that central bank independence eases the attainment of price stability at little or no real economic cost. The main factor motivating these central banks reform has been the belief that independence of central banks, with a clear mandate to maintain price stability, may be an institutional mechanism intended to increase the credibility of policymakers commitment to stable prices and to reduce the short-run output losses associated with lowering inflation through the change of private sector expectations [Rogoff, 1985].
Several empirical studies have found a negative correlation between inflation and central bank independence and no systematic relationship between central bank independence and real economic performances [Grilli et al., 1991; Cukierman, 1992; Alesina and Summers, 1993]. The credibility bonus of central bank independence is presumed to be the source of these results. However, an interesting body of recent empirical literature on the real cost of disinflation [including Debelle and Fischer, 1994; Gartner, 1995; Fischer, 1996; Jordan, 1997; and Posen, 1998] conclude that the output costs of disinflation are higher, not lower, in countries with independent central banks emphasizing that there is no "credibility bonus." (1) One of the most usual way to rationalize these somewhat surprising empirical findings is to assume that a high degree of central bank independence shifts the output inflation trade-off (or the Phillips curve) inwards while, at the same time, flattering it [Walsh, 1995]. The purpose of this paper is to add to the literature by providing a theoretical framework allowing for a formal demonstration of this explanation. In this context, if the degree of nominal wage indexation (or the wage contract length) is endogenous, the optimal monetary policy and the optimal degree of wage inertia are determined jointly through the strategic interactions between monetary authorities and private sector. In this environment, with the central bank more firmly committed to price stability, the outcome is that private agents opt for a lower degree of nominal wage indexation or longer wage contracts leading to more wage and price inertia [Mourmouras, 1997; Diana and Sidiropoulos, 2005].
The starting point of our analysis is the well-known time inconsistency problem associated with discretionary monetary policy, first analyzed by Kydland and Prescott [1977] and Barro and Gordon [1983]. The basic idea is that wage-setters recognize the policymaker's incentive to exploit the short-run Phillips curve. In equilibrium, unemployment is unaffected by monetary policy, but inflation is positive. Rogoff [1985] suggested that appointing a conservative central banker will reduce the inflationary bias at the expense of higher employment variability. In this paper, we extend the game-theoretic model of monetary policy developed by Rogoff [1985] by assuming that wage-setters choose optimally the degree of nominal wage indexation or contract length. We demonstrate that the optimal degree of wage indexation is negatively affected by the degree of central bank independence. As higher indexation steepens the short-run Phillips curve, our conclusion is that independent central banks face a flatter short-run Phillips curve and hence, their disinflationary policies are more costly.
The paper is organized as follow. The next section presents a one-period game model of monetary policy with indexed wage contracts. We then study the indexation behavior of the private sector and we demonstrate that the optimal degree of indexation is decreasing with the degree of central bank independence. Empirical evidence supporting our theoretical results is presented in the following section. The last section concludes.
The Model
The model developed here, is built around the Barro and Gordon [1983] and Rogoff [1985] models extended to allow for indexed wage contracts as in Gray [1976] and Fischer [1983]. It permits to study the strategic interactions between an optimizing monetary authority and rational individuals. This model consists of a simple aggregate supply- aggregate demand model in which the supply side behavior is influenced by indexed wage contracts and the demand side is driven by the quantity of money.
On the supply-side, labor is assumed to be the sole factor of production in the short run and the output is given by the following production function:
[y.sub.t] = a[l.sub.t] + [u.sub.t], < a < 1 (1)
where [y.sub.t]...
NOTE: All illustrations and photos have been removed from this article.
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