The Impact of Central Bank Independence on the It

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The impact of central bank independence on the performance of inflation targeting regimes* Sami Alpandaa, Adam Honiga**
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Amherst College, Amherst, MA 01002 May, 2011

______________________________________________________________________________ Abstract This paper examines the benefits of inflation targeting in both advanced and emerging economies. We do not detect significant effects in advanced economies and only find small benefits in emerging economies, in line with previous studies. However, when we differentiate the impact of inflation targeting based on the degree of central bank independence, we find large effects in emerging economies with low central bank independence. Our results therefore suggest that central bank independence is not a prerequisite for successful implementation of inflation targeting. Furthermore, we provide evidence that one channel through which inflation targeting lowers inflation more in countries with low central bank independence is the reduction of budget deficits following the adoption of an inflation target. JEL Classification: E52; E58 Keyword(s): inflation targeting; central bank independence _________ * We are grateful to Ricardo D. Brito and Brianne Bystedt for providing us with their data. ** Corresponding author: 315 Converse Hall, Amherst College, Amherst, MA 01002-5000. Phone: (413) 5425032. Fax: (413) 542-2090. Email: ahonig@amherst.edu

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Electronic copy available at: http://ssrn.com/abstract=1850835

1. Introduction A growing number of countries have adopted inflation targeting (IT) as a monetary policy strategy. This trend began in the early 1990s with a handful of advanced economies. By the mid-1990s, several more industrial countries followed suit, and by the late 1990s and early 2000s, central banks in emerging economies began adopting IT. The count is currently at 8 advanced economies and 13 emerging market countries. Central banks that implemented this new monetary policy framework did so because of the perceived benefits. These include achieving lower inflation and inflation variability, while retaining enough flexibility to respond to macroeconomic shocks and the ability to stabilize output. Emerging market countries in particular were searching for a nominal anchor that did not have the instability associated with fixed exchange rate regimes. As the number of countries that have adopted IT has grown, so too has the literature attempting to determine empirically the effects of IT on average inflation, inflation volatility, average growth, and growth volatility. Early studies focused on industrial countries (c.f. Ball and Sheridan, 2005) and, in general, found only weak evidence that IT improves macroeconomic performance. More recent studies include emerging economies and tend to find stronger evidence of positive effects (Batini and Laxton, 2007; Gonçalves and Salles, 2008; Lin and Ye, 2009; Mishkin and Schmidt-Hebbel, 2007). However, Brito and Bystedt (2010), using the GMM systems estimator as opposed to the commonly used difference-in-difference estimator employed in Ball and Sheridan (2005), obtain somewhat different results. They find weaker support for the effect of IT on average inflation, inflation volatility, and growth volatility and provide evidence that average growth is lower under IT. Surveying the literature, Ball (2010) states that the

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Electronic copy available at: http://ssrn.com/abstract=1850835

evidence of beneficial effects of IT in emerging economies, while stronger than in advanced countries, is not yet conclusive. In this paper, we attempt to explain the lack of strong evidence by arguing that all emerging economies are not the same and that IT may work better in some than others. In particular, central banks differ in their degree of central bank independence (CBI), and this may interact with an IT regime to produce different macroeconomic...
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