Fixed exchange rates, independent central banks and price stability in postcommunist countries: Conservatism and credibility

Abstract

Central bank independence (CBI) and fixed exchange rates are used by governments to achieve stable prices. This article analyzes the mechanisms through which the two monetary institutions could work: Indirectly via a disciplinary effect on money growth rates or via an additional credibility effect on inflation expectations and the cost of capital. I further explain how both discipline and credibility are affected by the distinct flaws of independent central banks and fixed exchange rates: central banks lack transparency and fixed exchange rates take many shapes and are routinely devalued. The argument is tested with quarterly data from postcommunist countries for years 1991 to 2007. The findings show a strong disciplinary effect of monetary institutions on rates of M2 change and an effect on inflation controlling for money growth, but credibility does not extend to lower real short-term market interest rates. Political institutions do condition the effect of central bank independence, while the types of fixed exchange rates affect money growth rates and inflation to different degrees.

The Side Effects of Central Bank Independence

“…Our immediate contribution is to the literature on the costs and benefits of CBI. The design of central banks has gained much attention in recent years (Adolph 2013;Ainsley 2017;Bodea 2010Bodea , 2014Hicks 2015a, 2015b;Goodhart 2015). This research has generally been consistent with the belief that giving independence to central banks is beneficial for macroeconomic performances (Cukierman 2008).…”

Price Stability and Central Bank Independence: Discipline, Credibility, and Democratic Institutions

“…4.See Cukierman, Miller, and Neyapti 2002; Arnone et al 2007; Jacome and Vasquez 2008; and Bodea 2014.…”

“…46.See Stockman 1996; Ghosh et al 1997; and Levy-Yeyaty and Sturzenegger 2001. Evidence for postcommunist states is in Bodea 2014. Other research suggests that adoption of specific (optimal) contracts like inflation targets can generate credibility and improve inflation performance.…”

Do Exchange Rates Influence Voting? Evidence from Elections and Survey Experiments in Democracies

“…Plümper and Neumayer 2011 show that exchange rate depreciations lead to a rise in inflation. In line with this, Bodea 2014 finds that stable exchange rates reduce inflationary expectations. See also Walter 2013.…”

“…28.Bearce and Hallerberg 2011; Bodea 2014; Broz, Frieden, and Weymouth 2008; Frieden 1991, 2015; Steinberg 2015; Walter 2008, 2013.…”