1

Central Bank Independence with Inflation Targeting

in Developed and Developing Countries

Paulo Chananeco F. de Barcellos Neto 1

Alexandre Englert Barbosa2

Abstract

The objective of this work is to discuss the existence of gains in having an independent

Central Bank in countries which adopt the Inflation Targeting. The division of the

sample into developed and developing countries applied to a structure of a panel data

has made possible to demonstrate that in developing countries which adopt the Inflation

Targeting and have independent central banks present lower interest rates, whereas in

developed countries the results were not statistically conclusive. Additionally, this

article presents a brief survey, which concerns about the independence of central banks,

in which most of the works done indicate the existence of economic gains for the

nations by providing independence for their monetary authorities.

Key words: Central Bank Independence, Panel Data, Inflation Targeting System.

JEL Classification: E5, E52, E58.

1Master of Science and PhD student in Economics (PPGE/UFRGS).2 Master of Science and PhD student in Economics (PPGE/UFRGS).We would like to thank Marcelo Portugal for his comments and suggestions, as well as Fatima Pederzollifor helping us in the translation of this paper.

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Introduction

The determination of a function that represents the action of central banks has

been treated in literature based on a reaction function proposed by Taylor (1993). By

adopting the Inflation Targeting System (hereafter ITS), many countries have succeeded

in controlling the inflation rate in a context of flexible exchange rate systems, besides

keeping the Gross Domestic Product of these nations oscillating close to their natural or

potential paths.

In conjunction with the dissemination and the relative success of the

implementation of this monetary policy arrangement, some questions still require

greater investigations. Undoubtedly, one of them is to try to explain why some nations

that have adopted this system present low benchmark interest rates and others need to

coexist with high rates. Certainly, the explanation for these differences lies on a great

amount of complex vectors, such as the level of the current inflation, the size of

economy, the profile and composition of public debts, the credibility in the economic

policy, the degree of economic openness, the conditions of external financing and the

institutional issues.

This article, in particular, aims at discussing the way this last factor, more

specifically the independence of central banks (hereafter CBI), has affected the

determination of the level of basic interest rate in a sample of developed and

developing countries which uses the ITS.

Many studies (Berger et al, 2001; McCallum, 1995; Cukierman, Webb and

Neyapti, 1992; Cukierman, 1992; Alesina and Summers, 1993; Alesina, 1989) were

held with the purpose of observing the relationship between inflation and CBI.

Generally, these works conclude that there is a negative correlation between inflation

3

and CBI. The literature usually takes into account a cross section3 analysis of several

countries, using either questionnaires about legal aspects of central banks and a turnover

index4 as a proxy for the CBI, so as to measure the actual independence, which is

important to developing countries.

In this way, it is expected that in countries which adopt the ITS with an

independent central bank, they present both lower inflation and interest rates, since this

is one of the main instruments for reducing it.

In order to measure this relationship, besides this introduction, this paper

contains three parts: in the second one, a synthesis of the way literature has been

treating the CBI and its relation with inflation will be presented; in the third part, an

econometric model will be estimated, as well as its results will be shown; and finally, in

the fourth part, the conclusions reached along the work will be exposed.

2. Central Bank Independence

Since the late 70’s and the early 80’s, the CBI has become one of the most

discussed issues within the scope of the monetary policy. Its origin is connected to the

dynamic inconsistency model by Kydland and Prescott (1977) and Barro and Gordon

(1983). In short, when the inflation expected is low in such a way that the marginal cost

of growth is reduced, there are incentives for policy makers to adopt expansionist

policies in terms of production, above the level of long run balance.

However, as the economic growth presents rational expectations, the behavior of

the bank is anticipated. Thus, besides the fact that the results in terms of growth of the

product do not occur, an increase of prices takes place, revealing a neutral behavior of

3 Works focusing only on one country were also carried out. See, for example, Panagiotidis andTriampella (2001) for an approach about the impacts of CBI on Greece.

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money. Therefore, a central bank which is not disconnected from the political interests

of the government may be dissuaded from implementing such policies, namely the

increase of money supply.

Constant temptations for policy makers to rise the economic growth, to request

the covering of budget deficits of the government by issuing money, and to generate

inflation by fiscal authorities are some of the traps that should be avoided by society,

taking into consideration the inflationary results. Considering these facts, some authors,

as McCallum (1995), defend the idea that one of the greatest advantages of

independence of these institutions is the isolation of the usual decisions of the monetary

policy from the pressures of political activity, inherent in the democratic process.

Rogoff (1985) adds that besides an independent central bank, this should be

conservative, referring to the fact that the “banker” should be more averse to risk than

the government.

More specifically, the first motivation mentioned above – of economic growth

via expansionist monetary policy – is related to the political cycle, which in this context,

may act by means of incoherent actions with the goals of the current monetary policy in

a country, such as the reduction of interest rates during pre-electoral periods in the

search of a short-run economic growth, despite of the consequences in terms of loss of

credibility which will have to be faced in the future. In relation to government deficits

covered by increases of money supply in its different forms, the risk is similarly high;

by the way, the economic literature has demonstrated that this has been the main cause

of hyperinflations observed throughout economic history, what makes the discussion

about CBI still more and more relevant.

According to Blinder (1998), the importance of an independent central bank lies

on the fact that by its own nature the monetary policy needs a long term horizon, which

4 It measures the turnover of central banks chairmen.

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indeed has not been observed neither by politicians, nor by society, who most of the

time are not even aware of the terrible effects a badly conducted monetary policy may

bring about.

The CBI can also be interpreted as the increase of the weight attached to the

objective of reducing inflation, in the sense used by Rogoff (1985). Yet, Alesina and

Summers (1993) and Eijffinger and Schalling (1993) have not identified any

relationship between the CBI and the volatility of the real economy for industrialized

countries, what cannot be seen as a contradiction5. In this way, there would be a free

lunch due to the CBI, reducing the inflation and at the same time not increasing the

output volatility. This could reflect either the existence of an inverse relation of cause of

aversion to risk for the CBI or the presence of a third factor responsible for both.

For Fischer (1995), even when there is an inverse relation of cause and effect, it

is probably first-best proposing a legislation to establish an independent central bank for

those who want to reduce inflation, leaving a few doubts that on average the economic

performance is better in countries with higher independence of the monetary authority.

Additionally, it is assumed as true that in industrialized countries, where the legal

clauses are stronger, the relation of cause and effect goes from independence to

reduction of inflation.

As the debate about central banks evolves, within a context of a generalized

increase of the autonomy of decisions of these institutions all over the world, the

discussion of the degree of independence turns out to be so important as the necessity of

independent central banks in their full conception. For this reason, concerning CBI, it is

important to highlight the difference between the independence of objectives and tools.

In the former, the institution determines its own goals to be pursued, instead of being set

by another governmental department. On the other hand, in the latter, the bank has the

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control over the instruments of the monetary policy (Debelle and Fischer, 1994).

Fischer, 1995 highlights that there is still the differentiation between independence and

autonomy: whereas the former refers to the independence of objectives and instruments

jointly, the latter takes into consideration only the independence of instruments.

In relation to the empirical tests, several works have been held in order to

estimate the effects of CBI over inflation, unemployment, and credibility of monetary

policy. (Cukierman, Webb and Neyapti, 1992; Alesina and Summers, 1993; Alesina,

1989; Grili et al, 1991)6.

Therefore, literature has shown that, for industrialized countries, independent

central banks are negatively correlated with the average inflation. By using a measure

of the CBI which includes formal and informal7 aspects, Cukierman, et al (1992) and

Grilli et al (1991) observe that, in general, there is an inverse relation between

independence and inflation, as well as a lower volatility of the latter. According to

Cukierman et al (1992), in all the countries analyzed, whose annual average inflation

has surpassed 50%, the CBI was below the median. Moreover, the results obtained have

demonstrated that, during the 80’s, the index that measures the independence of central

banks varied from 0.69 (Bundesbank), more independent, to 0.10 (Poland), less

independent.

In the study mentioned, it was noticed that in industrialized countries the

negative correlations between inflation and independence of central banks were higher

then the one calculated for the whole sample (with developed and developing

5 See McCallum (1995) for the reasons of the apparent contradiction.6 For some surveys related to the subject, see Berger et al (2001), Cukierman (1992), and Eijffinger andHann (1996).7 The informal measure consists of a research with Bank staff, comparing the correlation of legalindependence with the answers. In the industrialized countries, the correlation surpassed the one ofdeveloping countries. The focus on formal aspects stems from the pioneering analysis of CBI forindustrialized economies based on questionnaires done by Bade and Parkin(1982).

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countries). One of the possibilities for such fact to take place is the difference between

the real independence and the legal one. It can be observed a higher correlation between

the questionnaire-based index8 (informal measures of independence) and the legal

aspects (formal measures) for industrialized countries and very low to the entire sample,

what must indicate a minor respect to the legal aspects in developing countries.

Due to the discrepancy in the results of developed and developing countries, it

has been observed that exactly because of this minor tradition in terms of contracts

compliance, for the latter ones, it should have been added a variable capable of

measuring the actual independence, which was not only observed with the legal aspects,

caught by CBI legal index9. Therefore, some studies as Cukierman’s (1992) mentioned

above, included a turnover rate, which takes into account the turnover of the banker in

the post. As it was expected, it was proved that the lower the turnover is, the lower the

inflation in developing countries.

For developed countries, this variable was not significant, even though the CBI

legal index has caught the negative correlation with inflation (Cukierman et al, 1992 and

Cukierman, 1994). The refinement of the turnover measure of the banker was held by

Cukierman (1996), based on the propensity of the chairmen of central banks of losing

their post after political transitions10. Cukierman and Webb (1995) have come to the

conclusion that the average propensity of replacing the banker is higher after political

transitions and also that the vulnerability is greater in developing countries.

Fischer (1995) splits up the measure of independence of central banks into three

components: a) presence of a legal requirement to pursue the monetary stability among

8 Answered by central bank officials.9 The legal aspects were usually measured through questionnaires that referred to chairmen’s mandate andnomination, for instance. They also took into consideration the official objectives of central bank, legalrestrictions of loan obtained by public sector, juxtaposition of mandates. With these characteristicsadequately weighted, an indicator was reached. For more details, see Cukierman (1992).10 It was measured through loss of mandate, six months after the political transition.

8

the objectives of the central bank; b) measures relating the rights of central bank of not

financing the government and establishing the discount rate; and c) a combination of

legal provisions in regard with the relations and commitment of the bank with the

government. The author concluded that the factor which was more linked to the

inflation performance were “a” and “b”.

Nevertheless, the results founded in literature are not unanimous. As the debate

evolved, criticisms arouse referring to the theoretical presuppositions and the own

measurement of the degrees of independence of central banks. Hayo and Hefeker (2001)

assert that the CBI is neither a necessary, nor an enough condition for monetary

stability. Mangano (1998) presents some technical criticism about the structure of the

CBI indexes. Campillo and Miron (1997), through an empirical analysis, do not observe

any relationship between the variation of the average inflation of the countries and the

different degrees of independence of central banks.

According to Pollard (1993), the results of the empirical studies are deficient ,

since: the measurement of the degree of independence is complex; there may be a

spurious relationship between CBI and economic performance; possibility of

endogenous CBI; and the inclusion of periods of fixed exchange rates in some studies,

when the central bank should not be considered as responsible for monetary policy

Despite of some dissonant voices and possible errors committed during

measurement, the empirical results insist on showing that the CBI is indeed a way of

reducing inflation with low costs for society, besides increasing the degree of credibility

of the monetary policy throughout the time. In this sense, specially after the Golden and

Silver Standards and the Bretton Woods System, when the central banks became even

more responsible for the inflationary control, the CBI has been a measure adopted in

some countries to reduce inflation and its variability.

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3. Independence of Central Banks and Inflation Targeting System

As it was discussed in the previous section, a great part of literature that

concerns about the estimates of the effects of CBI in countries that adopt this measure is

centered in its own effects over the inflation. However, in this work, the focus is to

estimate the effects that independence exerts on the benchmark interest rate in a sample

of ten countries: Australia, Brazil, Canada, Chile, Colombia, South Korea, England,

Mexico, New Zealand and Sweden, whose the main characteristic in common is the fact

of adopting the inflation targeting system (ITS).

3.1 The Model

Probably, the most adequate manner of estimating the impacts that CBI has on

the level of the benchmark interest rate would be developing an individual study for

each country. Yet, because of the limited number of observations for some countries

that have adopted this system and have made modifications in the institutional structure

of their central banks after opting for the system of targets, it was opted to carry out

sectional estimation of panel data.

Mohanly and Klau (2004) have already used these methods to estimate the

effects of the ITS in countries which have adopted them. In particular, the uses of this

method as time and space dimension have been increasing its frequency in literature.

The most simple method of estimation is the one that ignores the structure of panel data,

characterized as sectional data, or models of pooled regression. Based on Taylor’s Rule

10

(1993)11, and making some alterations, the equation to be estimated will have the

following structural form:

itititititit BCICCGapi εβββπβα +++++= 4321 (1)

Where,

iit: quarterly average of the benchmark nominal interest rate of country i in period t:

πit: quarterly average of inflation accumulated in 12 months for country i in period t;

Gapit: quarterly output gap12 of country i in period t;

CCit: dummy variable that assumes unit value when a country i presented a deficit in

current account in the accumulated of quarter;

BCIit; dummy variable that assumes unit value when country i has independent central

bank in quarter t13;

βi:: estimated coefficient vectors

εit: error of regression.

Assuming that εit ~ iid (0,σ2) for all i and t means that for each country, the

observations are not serially related and, for countries and time, the errors are

homosckedastics. This specification can be estimated by the Ordinary Least Squares

Method (OLS), with the traditional interpretations of the validation tests. When the

estimations are considered in cross section, in conjunction with the data in time series in

a panel data structure, the presentation of some peculiarities is necessary. From the

equation (1), a panel structure can be presented in the following way:

itititititiit BCICCGapi εβββπβα +++++= 4321 (2)

Where,

11 A more detailed discussion of a reaction function can be found in Taylor, J (1993). Discretion versuspolicy rules in practice. Carnegie-Rochester Conference Series on Public Policy, p. 195-214.12 The output gap was calculated by using the HP filter and having as a reference the quarterly output inseasonally adjusted level by the authors by means of ARIMA X-12 method.13 In this work, it will be assumed that a central bank is independent when it is guaranteed in thelegislation.

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αi = α + ui (3)

is the individual effect, constant during the whole time and specific for each country.

The OLS method provides consistent estimates of data if the αi’s are equal for all

countries: on the other hand, when this does not occur, two structures exist that

generalize this model. The first, called fixed effects, considers the term constant in the

regression model, while in the second, named random effects, considers that αi is a

particular group of errors. Thus, the difference between both methodologies is in the

form of treatment of term αi.

The structure of fixed effects assumes that all the differences of behavior

between the countries along the time can be caught by the constant term. Thus, each αi

is an unknown parameter, which can be estimated in two ways. The first is to apply the

Least Squares Dummy Variable (LSDV) method, that confers an unit value for each

country i and the coefficients of αi are equivalent to the intercepts of each country. A

second way, which will be applied in this paper, the within and between estimators. In a

first moment, it is made a transformation in equation (2), estimating a model based on

the average of the exogenous variables and of the endogenous one, with the purpose of

eliminating the effect not observed ui. That is, the following equation is estimated:

iiiiiii uBCICCGapi__

4

_

3

_

2

_

1

_

εβββπβα ++++++= (4)

Where the dashes represent the average of the respective terms of equation (2).

Subtracting the equation (4) from equation (2) for each t, the result is an equation that

represents the deviations of the group’s average, represented by:

__

4

_

3

_

2

_

1

_

)()()()( iitiitiitiitiitiit BCIBCICCCCGapGapii εεβββππβ −+−+−+−+−=− (5)

12

By subtracting the temporal effect of equation (2), the specific effect of each

country ui was removed. By estimating the equation (5) by OLS, the within estimator is

obtained. It is considered that the within estimator is equal to the one obtained by

LSDV. The between estimator is obtained through the equation (5) and reflects only the

variation between the cross section observations.

In relation to the model with random effects, the intercept starts to be treated as

random extractions of the population distribution of intercepts of countries individually,

that is, the equation (2) is estimated, taking into account that the term ui is taken as a not

observable random error, which answers for individual differences in countries

behavior. It is assumed that E(ui) = 0 e var(ui) = σu2. Replacing the equation (3) in (2)

and making vit = ui + εit,, we have:

itititititit vBCICCGapi +++++= 4321 βββπβα (6)

The stochastic term vit is composed by two components: the error εit and the

specific individual error ui, which is related to each country characteristics, but constant

in time. Once estimated the equations by the fixed and random effects methods, all it is

needed to know is which one is the most adequate for the purpose of this work. This

choice can be done by means of the accomplishment of Hausman Test. This test is built

based on the differences between the estimates obtained by the fixed effects and random

effects methods.

The estimator of fixed effects is consistent when E(uit/Xit) is different from zero,

but in this case, the estimator of random effects is inconsistent. Thus, one statistically

significant difference is interpreted as an evidence that the random effects are not

consistent. The statistics of the test is given by:

)(~)())(( 2^^

1^^^^

kVVH aleatóriofixoaleatóriofixoaleatóriofixo χββββ −−−= − (7)

13

Where k is the number of coefficients estimated, excluding the intercept and the

invariant regressors in time.

3.2 Empirical Results

By starting from a specification of the modified reaction function, as it was

presented in equation (1), the objective is to catch the effects that the CBI has over the

level of benchmark interest rate. The data used were obtained in the respective official

institutes and collected in central bank websites, in a quarterly periodicity, with data for

the ten countries including the period between the third quarter of 1999 and the fourth

quarter of 2003.

The first step adopted was estimating the model in panel data for all countries

through the two methods presented in section 3.1. The results contained in Table 1

presented as main characteristics the high degree of significance of the estimated

coefficients, except for the result in current account that did not present statistical

significance in none of the ways estimated for the whole sample of countries.

Only in the random effects model – estimated by the Generalized Least Squares

(GLS) – the “dummy” variable that assumes the unit value, whenever the central bank

of a country i is independent, demonstrated to be possible of estimation. In this way, the

accomplishment of some procedures that would validate this estimate became

necessary. Therefore, in order to identify which of the two methodologies is the most

appropriate in this sample of data, the Hausman Test was applied, presented in Table 2.

As this test suggests, the specification obtained by the fixed effects method is rejected in

such a way that the values of the estimated coefficients in the model of random effects

are the most adequate.

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These results satisfactorily suggest that by controlling the output gap factors,

level of the current inflation, and the result in current accounts, countries with

independent central banks in the entire sample tend to coexist with lower interest rates.

In order to deepen the degree of specification of this result, a stratification of the sample

between developed and developing countries was done, since these results can be better

analyzed based on this decomposition.

Table 1

Results of the Estimates in Panel Data for the Sample of Countries with IT

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16

Fixed Effects (OLS)

Random Effects (GLS)

Dependent Variable: Benchmark Interest Rate

π 0.858*** (0.078)

0.927*** (0.077)

Gap 0.117** (0.052)

0.111** (0.054)

CC 0.013 (0.474)

0.182 (0.460)

CBI -4.664*** (1.260)

Constant 4.002*** (0.536)

6.863*** (1.256)

R2: Within 0.483 0.482

R2: Between 0.927 0.834

R2: Overall 0.777 0.782

Sigma u 3.451 1.667

Sigma e 1.553 1.553

Rho 0.832 0.536

(*) 10% significant, (**) 5% significant and (***) 1% significant. Standard deviations are in brackets.

The estimates were accomplished by pooled, as the size of the sample has not

permitted an estimate by panel data. Although it does not permit to extract the

individual effects of the sample countries, they have the estimated coefficients equal to

the ones obtained when the random effects method is accepted. The results found based

on this opening (presented in Table 3) keep high levels of acceptance of the estimated

coefficients.

Table 2Hausman’s Test

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Coefficients Variable Fixed Effects Random Effects Difference π 0.8583 0.9275 -0.6916

Gap 0.1170 0.1114 0.057 CC 0.1345 0.1819 -0.1684

H0 test: the differences in the coefficients are not systematic

)3(~)())(( 2^^

1^^^^

χββββ randomfixrandomfixrandomfix VVH −−−= − (Prob>λ2) = 0.5201

The accomplishment of this opening demonstrates an important difference

between the relevance of CBI in developing countries in relation to developed countries

of the sample14. In the first group of countries, the regression presents itself highly

adherent to data with a R2 equal to 0.91 and all the coefficients are significant.

Controlling by the other exogenous variables, the model indicates that having a CBI in

the developing countries group in a context of ITS decisively affects the level of the

benchmark interest rate.

In the case of developed countries, the independence of these institutions are not

significant to explain the level of interest rates of these countries. This result may be

associated to the fact that the specification of the model estimated did not have a good

performance in this group of countries or to the supposition that in developed countries

14 It is assumed as group of developed countries - England, Sweden, New Zealand, Canada and Australia;and as a group of developing countries - Brazil, Chile, Mexico, South Korea and Colombia.

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the degree of confidence in the institutions is so high that the independence of central

banks ends up by not affecting the level of interest rates adopted in these countries.

Table 3

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Results of the Pooled Data Estimates for the Stratified Sample between Developedand Developing Countries with ITS

20

21

Developed Countries Developing Countries

Dependent Variable: Benchmark Interest Rate

Pooled Data

π 0.185** (0.082)

1.219*** (0.087)

Gap 0,120*** (0.045)

0.120• (0.083)

CC 1.037*** (0.199)

0.745* (0.460)

CBI 0.397 (0.257)

-6.123*** (0.579)

Constant 3.245*** (0.428)

6.687*** (0.874)

R2: 0.348 0.914

R2: Ajusted 0.316 0.909

F(4,80) 10.680 211.600

Prob > F 0.000 0.000

(*) 15% significant, (*) 10% significant, (**) 5% significant and (***) 1% significant. Standard Deviations are in brackets.

4. Conclusion

Throughout this work, it has been analyzed to what extent the independence of

central banks in countries that adopted the Inflation Targeting System affects the level

of benchmark interest rate in a sample of nations. In the first section, it has been

presented some of the main arguments found in literature that deal with the CBI theme,

in which it was possible to identify that the principal issue is not whether these

institutions should have independence or not – since the benefits of this measure are

significant -, but which level of independence should be adopted.

In regard with the results estimated for the sample of countries with inflation

targeting system, based on a Taylor Rule modified, the results obtained suggest that the

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countries which reconcile targets with central banks independence, on average, coexist

with lower benchmark interest rates. Cukierman (1992) demonstrated that the CBI in

developed countries has presented an inverse relation with the inflation level, while in

the sample of developing countries, this relation has not been found.

In the present work, the results point to an inverse direction, that is, the

developing countries with inflation targeting system which have independent central

banks present on average benchmark interest rates 6% lower to the ones found in the

other countries of the sample, whereas in developed countries, which also adopted the

inflation targeting system, the coefficient was not significant.

As it has been observed, the literature shows that it is important to evaluate the

CBI in developing countries considering the turnover , what consists in one of the

limitations of this work. The turnover index could help in the results, since the measure

used in this study concerns only about the legal situation of the central bank of each

country, which many times differs from the real degree of independence. Thus, future

works might be developed with the inclusion of the variable referred to, even though, as

it can be observed in literature, in general this one is only able to catch the CBI in

developing countries, what was obtained in the estimates accomplished even without its

presence.

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