Monetary Policy Uncertainty and Central Bank Accountability

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 18 October 1996

Working Paper No. 54
By Charles Nolan and Eric Schaling

Recently in many countries both political and monetary authorities have shown increasing interest in achieving and maintaining price stability. To that end, a number of institutional reforms have taken place in many developed and developing countries. In general, the reform process followed two distinct routes. The first is where the central bank is made independent by act of law and left largely to its own devices to achieve price stability. The second route is where the government introduces a target for a nominal magnitude, say an inflation or money target, and then makes the central bank accountable for achieving this target.

Both approaches have their proponents and critics. For instance, one well known concern with the creation of an independent central bank is that it might permit unaccountable and unelected officials to elevate their preferences (over the level of inflation and with respect to inflation versus output stabilisation) above society's. To put the point slightly differently, independence without accountability may permit the central banker to behave in an opportunistic manner which will not further society's objectives. This is the focus of our investigation.

The notion of accountability is somewhat difficult to pin down precisely. We approach this issue by noting that at one level accountability is simply a mechanism whereby agents' actions are made apparent to the principal. Within the context of our monetary policy 'game' this simply means that agents' (ie central bank officials') actions are more closely aligned with society's preferences. Or alternatively, penalty mechanisms can be more accurately calibrated in order to induce appropriate actions on the part of the agent. We show that if agents are unsure of how the central bank is going to act (ie there is uncertainty over the central bank's inflation versus output stabilisation preferences) their expectations of inflation are less accurate than they otherwise would be. And in general it is likely that inflation expectations are higher. From this, then, it follows that inflationary expectations may be reduced both by an increase in accountability, and/or an increase in the degree of central bank independence. Following on from this we also show that for a given target level of inflation the optimal degree of central bank accountability is higher, the lower is the degree of central bank independence.

We also show that accountability cannot get rid of all of the inflation bias on its own. This is not surprising since what creates the bias in the first place is the desire for a higher average output level. The key point is that a lack of accountability can react with this bias to create a worse problem than would exist had effective institutions been in place to ensure accountability.

Although it is difficult to test our theory directly, we show that it may well be consistent with real-world institutions. Central banks which have a higher degree of independence also appear to be less accountable.

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