Debt, Inflation and Central Bank Independence

Abstract

Increasing the independence of a central bank from political influence, although ex-ante socially beneficial and initially successful in reducing inflation, would ultimately fail to lower inflation permanently. The smaller anticipated policy distortions implemented by a more independent central bank would induce the fiscal authority to decrease current distortions by increasing the deficit. Over time, inflation would increase to accommodate a higher public debt. Alternatively, imposing a strict inflation target would lower inflation permanently and insulate the primary deficit from political distortions.

Central Bank Independence and Inflation: the Government debt and Inflation Targeting channel

“…In fact, there is a weak positive correlation between Central Bank Independence and inflation, growth rate, the level of government debt and the budget deficit. This initial result should of course be compared with Sargent and Wallace's analysis (1981) as well as that of Martin (2015).…”

“…But in the long term this compromises the ability of the central bank to control price stability. For Martin (2015) inflation must inevitably increase in order to contribute to the sustainability of government debt. On the basis of this theoretical literature a positive relationship should be identifiable between the degree of independence, the level of debt and the level of inflation.…”

“…At that stage, according to Martin's (2015) model, only a strategy of Inflation Targeting could, a priori, break this link.…”

“…We choice as framework a more recent and realistic model. According to Martin (2015), the increase in debt and reduction in inflation experienced in the US and other developed countries in the early 1980s was plausibly the combined outcome of increased Central Bank Independence and lower tolerance of inflation by agents. In Martin's macroeconomic model the smaller anticipated policy Finance Bulletin 1:2 distortions implemented by a more independent central bank would induce the fiscal authority to trade off higher current deficits for lower future deficits.…”

Interconnections between Public Indebtedness and Inflation in Contemporary Economies

“…The degree of central bank independence to the government, in other words the ability of public authorities to influence the stance of monetary policy, as well as the credibility of the latter are factors determining the possibility of promoting inflation in order to reduce the real burden of public debt (Krause and Moyen, 2013;Martin, 2013). Ensuring the full independence of the central bank reduces the risk it promotes inflation to amortize public debt, while a low degree of monetary policy credibility makes it possible for inflation to be at least partly anticipated, being reflected in higher interest rates requested by cash holders when lending money to governments.…”