Bureaucratic Delegation and Political Institutions: When are Independent Central Banks Irrelevant?

Transcription

1 Buraucratic Dlgation and Political Institutions: Whn ar Indpndnt Cntral Banks Irrlvant? Philip Kfr Dvlopmnt Rsarch Group World Bank David Stasavag ondon School of conomics This papr s findings, intrprtations, and conclusions ar ntirl thos of th authors and do not ncssaril rprsnt th viws of th World Bank, its xcutiv Dirctors, or th countris th rprsnt.

2 Astract: Dlgation to indpndnt agncis is oftn suggstd as a rmd for politicallmotivatd infficincis in govrnmnt dcision making. For xampl, irrvocal dlgation to an indpndnt cntral ank can mitigat th inflation ias cratd political incntivs to rng on polic commitmnts. In practic, howvr, th irrvocailit of dlgation dpnds on th spcific institutional dtails of political dcision making. W dvlop a modl of montar polic that idntifis, first, th indpndnt ffct of ths institutions on inflation xpctations and, scond, th additional ffct of dlgation to an indpndnt cntral ank. W find mpirical support for th modl in tsts of thr prdictions: th prsnc of an indpndnt cntral ank should rduc inflation onl in th prsnc of political chcks and alancs; political intrfrnc with th cntral ank should mor apparnt whn thr ar fw chcks and alancs; and th ffcts of chcks and alancs should gratr whn political dcision makrs ar mor polarizd.

3 . Introduction Th dlgation of dcision making political actors to indpndnt agncis has n th sujct of grat dat and analsis in oth political scinc and conomics (s, for xampl, pstin and O Halloran (999), affont and Tirol (990), and McCuins, Noll and Wingast (987). On qustion continus to k to this dat: to what xtnt dos dlgation to an indpndnt agnc (or judiciar) lad to polic outcoms diffrnt than thos that political actors would othrwis hav adoptd? This papr is concrnd with on important variant of this qustion, th xtnt to which dlgation maks polic announcmnts mor crdil to privat actors than polic announcmnts mad in th asnc of dlgation. That is, ar privat actors mor likl to mak fixd invstmnts or suscri to long trm contracts whn polic making has n dlgatd to an indpndnt agnc? Although th answr to this qustion has implications for conomic polic in aras ranging from capital taxation and utilitis rgulation to antitrust rgulation, a natural arna to invstigat it is montar polic. Th litratur has uilt up a larg od of knowldg that suggsts a potntiall important rol for indpndnt cntral anks. Howvr, ths rsults ar gnrall otaind undr th assumption that dlgation of polic making is irrvocal: if dlgation is irrvocal and agnc prsonnl gain nothing from rnging on polic announcmnts, privat actors ar likl to find policis undr dlgation to mor crdil. Howvr, dlgation is invital a political choic which in practic can rvrsd. In this papr w thrfor xamin polic making with and without dlgation, rlaxing th assumption that dlgation is irrvrsil. W compar th crdiilit of montar polic undr thr institutional arrangmnts: govrnmnt with a singl dcision makr, with chcks and alancs, and with chcks and alancs and dlgation to an indpndnt cntral ank. Within ths arrangmnts, w

4 considr additional variants rlatd to th assignmnt of agnda control and th xtnt of political polarization. In th scond half of th papr, w offr dtaild mpirical tsts that strongl support th modl's prdictions. Ths tsts us nw data oth on political institutions and on political polarization and show for th first tim that, controlling for political institutions, lgal cntral ank indpndnc can rduc inflation in oth dvloping and dvlopd countris, and that this ffct dpnds on th xtnt to which political dcision makrs ar polarizd.. A rviw of solutions to th crdiilit prolm Th tim consistnc prolm in montar polic, idntifid Kdland and Prscott (977) and Barro and Gordon (983a), is wll-known: a govrnmnt rprsntd a singl actor which maks an initial announcmnt of montar polic will hav an incntiv to gnrat incrasd inflation onc th privat sctor has formd its inflation xpctations. Anticipating this x post incntiv, privat agnts uild this inflation ias into thir wag contracts. Barro and Gordon (983) proposd that rputational ffcts can solv th timconsistnc prolm. Givn a sufficintl high discount factor, th thrat of futurs losss imposd pric-sttrs rvising thir inflation xpctations upwards will man that a govrnmnt has mor to los from rnging on its inflation announcmnt than it stands to gain from tmporar positiv shocks to incom. Howvr, th rputational outcom is ut on of multipl possil quiliria in this infinitl rpatd gam. Morovr, for man govrnmnts hav discounting of th futur will liminat rputational quiliria. Prssurs to avoid th nxt coup or to win th nxt lction will sufficintl grat that a govrnmnt will not valu futur losss mor highl than currnt gains from opportunistic havior. Similar prolms of multipl quiliria aris whn montar polic is modld as a rpatd gam with incomplt information, whr rputational ffcts involv changing lifs aout a polic makr's "tp".

5 Rogoff (985) suggstd that th dlgation of montar polic to an indpndnt cntral ank that placs gratr wight than socit at larg on stailizing prics rlativ to stailizing output could an altrnativ solution to th tim-consistnc prolm. H assumd awa th possiilit that political actors might rvrs thir dcision to dlgat or that th might othrwis influnc dcisions takn th cntral ank. Narl all susqunt rsarch has rtaind this assumption. Howvr, sustantial vidnc from th stud of Amrican politics suggsts that partisan idntification of political actors affcts th dcisions of nominall indpndnt uraucratic agncis (Wingast and Moran, 983; also Muris commnt and thir rjoindr (984)). ohmann (998) and Mosr (999) rlax th irrvrsiilit assumption in thir analss of cntral ank indpndnc. As w do, th argu that multipl vto plars in govrnmnt mak it mor difficult to rvrs a dcision to dlgat, giving indpndnt cntral anks gratr scop to rduc th inflation ias. 3 In our thortical and mpirical analsis w addrss svral qustions not ncompassd thir contriutions. Undr what conditions do chcks and alancs, thmslvs, mitigat th crdiilit prolm that incrass xpctd inflation? How do changs in agnda control and political polarization affct th impact of chcks and alancs on firm xpctations? Givn chcks and alancs, th assignmnt of agnda-stting authorit and political polarization, what additional influnc dos an indpndnt cntral ank hav on xpctd inflation? Mor rcnt modls of cntral ank indpndnc involving incntiv contracts (Walsh, 995; Prsson and Tallini, 993) or inflation targts (Svnsson, 997) assum that cntral ank indpndnc is irrvocal. ohmann (99) suggsts that socit could improv on Rogoff's solution of dlgation to a consrvativ cntral ankr if thr wr implicit scap clauss in th cas of svr suppl shocks, ut th mchanism through which ths clauss would nforcd is not spcifid. 3 In this papr w us th trms vto plar and political actor intrchangal. 3

6 3. A modl of chcks and alancs, cntral ank indpndnc and inflation Th modl of th tim consistnc prolm in montar polic that anchors this papr follows Barro and Gordon (983a). Th govrnmnt minimizs () ( G = t G t ) with rspct to, whr () t = t t t, whr = xpctd inflation, th pric incrass that ar programmd th privat sctor in thir contracts prior to th ralization of th conomic shock and th polic dcisions of th govrnmnt and whr is dsird output. Contracts ar writtn first, stting prics and forming xpctations aout inflation, thn a shock to th conom is xprincd, and thn th govrnmnt sts actual inflation. Privat actors know that, aftr th shock is ralizd, govrnmnt will st inflation dpnding on thir own contractual dcisions that st xpctd inflation, givn. That is, th govrnmnt will solv for th inflation outcom that minimizs its losss, or, from th minimization of (): (3a) C ( ) i =. i Aftr taking xpctations, solving for xpctd inflation and sustituting ack into (3a), th prolm ilds th following wll-known solution for inflation (supprssing tim suscripts hr and throughout). (3) = G G G. Th inflation ias th amount of xtra inflation gnratd th inailit of th govrnmnt to crdil commit to its announcd inflation polic is G. 4

7 Discrtionar montar polic undr chcks and alancs Th modl in this papr is dvlopd in two stags. In th first, a scond political actor is introducd. To captur th ida of chcks and alancs, oth political actors must agr on an chang in polic. 4 In th scond stag, w add an indpndnt cntral ank. Th two political actors, and (th xcutiv and lgislatur), minimiz loss functions as dscrid () and (): (4) i ( i ). = ach has diffrnt prfrncs,, >0, with rspct to th tradoff twn incom and inflation. W xamin oth th cas whr <, whr th xcutiv is mor inflationavrs than th lgislatur, and th rvrs cas, <. Th suppl shock is uniforml distriutd ovr [-c, c]. Th ordr of vnts is th following. First, pric-sttrs writ wag contracts, fixing xpctd inflation. A shock occurs and political actors thn dcid what montar polic to adopt. Th action takn govrnmnt, if an, dpnds on th ralization of th suppl shock t. If political actors do not agr on a nw rat of inflation, a dfault inflation outcom prvails. Th dfault option is an important fatur of th modl sinc, in ral-world dcision making, th outcoms that aris from doing nothing affct th willingnss of vto plars to accpt nw polic proposals. 5 Th procss outlind in quations () and () allows inflation to diffr from xpctd inflation onl if govrnmnt dcision makrs undrtak som polic action 4 Thr ar a numr of rasons wh multipl political actors might hav an influnc on montar polic in th asnc of chcks and alancs. In a parliamntar sstm, for xampl, th ministr of financ has nominal control of montar polic, ut montar polic dcisions ma wll datd in caint or among mmrs of th govrning coalition. In prsidntial sstms, lgislaturs ma xrcis vto powr ovr th orrowing authorit of govrnmnt. 5

8 aftr th ralization of th shock. If govrnmnt dcision makrs cannot agr to undrtak an action, thn w assum that actual inflation aftr th shock is ralizd quals xpctd inflation th wag incrass that privat actors hav uilt into thir contracts prior to th shock. As in th original Barro-Gordon modl, privat agnts writ thir contracts prior to th shock, anticipating that ach political actor would most prfr th following inflation polic aftr th shock (conditional on th pric inflation th hav uilt into thir contracts): 6 (5) i ( ) i =. i Sinc th prfrncs of th xcutiv and gislatur divrg, th inflation outcom dpnds on how thir individual prfrncs ar rflctd in th final govrnmnt dcision. That is, th inflation outcom dpnds on th dcision making ruls usd to mak polic. W assum that th dcision making procss ndows th xcutiv with agnda-stting authorit th ailit to mak a tak-it-or-lav-it offr to th othr dcision makr. Th xcutiv ma mor or lss inflation-tolrant than th gislatur ( ma gratr than or lss than ). 7 W solv for xpctd inflation, as usual, through ackwards induction. In th last priod, th political actors osrv xpctd inflation th contracts fixd in th privat sctor and th suppl shock. From (5) w know that th siz of th shock affcts whthr ach dcision makr s x post prfrrd inflation outcom is gratr or lss than xpctd inflation: th largr th suppl shock, th lowr is th inflation rat prfrrd th political dcision rlativ to xpctd inflation. Aftr th shock is ralizd, thr ar thr possil ordrings of th 5 Th sminal articl is Romr and Rosnthal (979). This is a crucial diffrnc twn our modl and that prsntd Mosr (999), who assums that undr pur chcks and alancs th two actors alwas chang inflation through a argaining procss whr th minimiz th sum of thir loss functions. Nithr actor is prmittd to rjct this solution in favor of th dfault outcom. 6 Minimizing (4) with rspct to and solving for it from th first ordr condition. 6

9 prfrrd inflation outcoms of th xcutiv and gislatur rlativ to th dfault inflation outcom. Whn <, ths ar < < ; < < ; and < <. Whn <, th ordring is th rvrs: > > ; > > ; and > >. In ach cas, ths thr alignmnts giv ris to four possil inflation outcoms. Th privat actors attach proailitis to ach of ths outcoms in stalishing thir inflation xpctations. Th four outcoms grman to th cas whr th xcutiv is lss inflation-tolrant than th gislatur ar: Cas I: < < In Cas I, aftr th suppl shock is ralizd, oth th gislatur and xcutiv prfr an inflation outcom gratr than th dfault outcom. Sinc th xcutiv has agnda control, sh can thrfor propos hr most prfrrd outcom, which is gratr than th dfault outcom, and th gislatur will agr to it. Givn xpctd inflation, govrnmnt dcision makrs thrfor agr on th inflation outcom dscrid in (6): (6) ( ) =. Cas II: < < With this alignmnt in prfrncs, thr is no inflation outcom that th xcutiv would prfr to th dfault outcom and that th gislatur would accpt. Hnc, th dfault outcom is rtaind. In this cas, xpctd inflation and actual inflation ar th sam, x post, and: (7) = 7 In th litratur on lgislativ argaining th actor with agnda stting powr is somtims chosn randoml natur (.g., Baron and Frjohn, 987, 989). This is unncssar in th cas of montar polic, whn th most plausil assumption is that privat actors osrv th idntit of th agnda sttr prior to writing thir contracts. 7

10 Cas III: < < <. In oth Cass III and IV, th gislatur and xcutiv prfr lowr inflation than would prvail undr th dfault outcom. Dpnding on th siz of th suppl shock, thr ar two possil inflation outcoms th xcutiv might propos, on givn Cas III and on Cas IV. Th xcutiv would lik to choos th lowst inflation outcom possil that mts th condition that th gislatur is indiffrnt twn th low inflation outcom and th dfault outcom. Th losss of govrnmnt dcision makrs ris as inflation outcoms dviat aov or low thir prfrrd inflation outcoms. It is thrfor fasil for th agnda sttr (th xcutiv) to succssfull propos an inflation outcom lss than th gislatur s prfrrd inflation outcom whn dfault inflation is aov th gislatur s prfrrd outcom. W assum that th xcutiv follows a simpl rul in slcting this altrnativ: sh chooss an inflation altrnativ such that th diffrnc twn th gislatur s prfrrd outcom and th proposd altrnativ is qual to th diffrnc twn dfault inflation and th gislatur s prfrrd outcom. 8 That is, an inflation outcom is chosn such that =, or ( ) (8) =. 8 In principl, th xcutiv should propos an inflation polic such that ( ) = ( ). Th xprssion for rsulting from this quadratic quation, howvr, rndrs susqunt analsis intractal. To rtain tractailit without sacrificing prdictiv powr, w assum that th gislatur is indiffrnt twn inflation that is x points highr than its prfrrd outcom and x points lowr. W know, from diffrntiating (4) with rspct to, that losss actuall incras fastr at highr lvls of inflation. Th impact of our assumption is thrfor to undrstat th xcutiv s agnda stting authorit whn < : strictl spaking, if dfault inflation is x points gratr than th gislatur s prfrrd outcom, th xcutiv can actuall mak an offr to th gislatur mor than x points low th prfrrd outcom. B th sam tokn, th assumption ovrstats th argaining powr of th xcutiv whn <. 8

11 Cas IV: < < < Undr Cas IV th dfault is sufficintl larg rlativ to th gislatur s prfrrd outcom that > =. B following th dcision rul in Cas III th xcutiv would ovrshoot, and choos an inflation outcom vn lowr than hr prfrrd outcom. In this situation, Cas IV, thrfor, th xcutiv instad chooss = or, as in Cas I, (9) ( ) =. Privat actors thrfor fac four possil ractions govrnmnt to th contracts that th sign, givn (6) - (9). Thir calculation of xpctd inflation is thrfor th solution to ( ˆ ˆ ˆ ) ( 3 ) ( 4 ) (0) = q q q3 q4 whr th qi s ar th proailitis that th govrnmnt will choos ach of th four diffrnt inflation outcoms aftr th shock is ralizd. Th sum to on. Th ˆ i ar th xpctd valus of th conomic shock conditional on th particular cas arising. For xampl, taking xpctd inflation as givn, it is vidnt that Cas IV can onl mrg for high ralizations of th suppl shock; ˆ 4 is th xpctd valu of th suppl shocks ovr th rang of shocks conditional on Cas IV occurring. Assuming a uniform distriution for, on can driv xprssions for th proailitis and for th xpctd shocks, and thn for xpctd inflation. This drivation is found in Annx, whr quation A. is th quadratic quation that givs th solution to xpctd inflation. Annx also prsnts th cas whr th xcutiv is mor inflationtolrant than th gislatur ( < ). quation A.3 is th xprssion for xpctd inflation in this cas. 9

12 W can us numrical simulations asd on quations A. and A.3 to gnrat comparativ statics from th modl to assss changs in xpctd inflation whn w mov from th xcutiv as sol dcision makr to chcks and alancs. First, what is th impact of th assignmnt of agnda control on th ffct of chcks and alancs? Scond, what is th impact of man-prsrving polarization of th prfrncs of th two dcision makrs, whr manprsrving is dfind as an incras in holding ( ) constant? Figur illustrats th answrs to ths qustions. Figur shows that xpctd inflation is far lowr if th agnda sttr (xcutiv) is mor inflation-avrs (th lowr part of th figur) than mor inflation-tolrant (th uppr part). Anothr wa to s th importanc of th agnda sttr is to considr th cas whr thr is no agnda sttr and th two actors simpl agr to minimiz th sum of thir loss functions. In this cas, th inflation ias quals ( ). 9 Undr th assumptions of Figur, this rsults in an xpctd valu of inflation of 3 for all lvls of polarization, lowr than if thr is an inflation-tolrant agnda sttr, and highr than if th agnda sttr is inflation-avrs. Rgardlss of th prfrncs of th agnda sttr, xpctd inflation lis incrasingl low th xcutiv-onl cas as dcision makrs ar mor polarizd; this ffct is mor pronouncd whn th agnda sttr (th xcutiv) is lss inflation-avrs. This asmmtr is xplaind th fact that polarization has two ffcts that oprat diffrntl dpnding on whthr th agnda sttr is mor or lss inflation-avrs. First, as polarization incrass, th rang ovr which th political actors cannot agr to an chang in montar polic Cas II also incrass. This should rduc xpctd inflation rgardlss of th idntit of th agnda sttr sinc, in th rgion whr polic makrs ar unal 9 This is th institutional st-up assumd in Mosr (999). 0

13 to agr on a nw inflation outcom, th ar in particular unal to agr on an incras in mon suppl to tmporaril oost output at th xpns of incrasd inflation. In Figur, whn th xcutiv is th mor inflation-avrs actor, an incras in polarization from zro to thr lads to an incras in th proailit of landing in th gridlock rgion from zro prcnt to prcnt. Whn th xcutiv is th lss inflation-avrs dcision makr, an incras in polarization from zro to.6 lads to an incras in th proailit of rtaining th dfault inflation outcom from zro prcnt to 8 prcnt. Scond, though, th proailit of Cas IV of a suppl shock so grat that th gislatur prfrs th xcutiv s prfrrd outcom to th dfault outcom drops. This attnuats th lvrag of th agnda sttr, sinc hr ailit to propos hr own prfrrd outcom diminishs. In th cas of th lss inflation-tolrant xcutiv, for xampl, dpictd in th lowr part of Figur, th proailit of Cas IV drops from 50 prcnt to 3 prcnt as on movs from no polarization to polarization qual to thr. Whn th xcutiv is mor inflation-tolrant than th gislatur, this proailit drops from 50 prcnt to 30 prcnt as polarization incrass to.6. Sinc a rduction in th proailit of Cas IV ssntiall rducs th wight of th agnda sttr s prfrncs in xpctd inflation, th rduction has th ffct of incrasing xpctd inflation whn th agnda-sttr is mor inflation-avrs, ut rducing it whn th agnda-sttr is lss inflation-avrs. Whn th agnda sttr is mor inflation-avrs, th incrasing proailit of Cas II and th falling proailit of Cas IV offst ach othr. Consquntl, th prsnc or asnc of chcks and alancs crats onl a small diffrnc in xpctd inflation at all lvls of polarization (th lowr part of Figur ). Howvr, whn th agnda sttr is mor inflation tolrant, th incrasing proailit of Cas II and th dclining proailit of Cas IV oth oprat to rduc xpctd inflation; hnc, th mor notal impact of polarization whn th

14 Figur : Th ffct on xpctd inflation of chcks and alancs, agnda control, and polarization xcutiv mor inflation-tolrant xcutiv onl Chcks and Balancs xcutiv lss inflation-tolrant xcutiv onl Chcks and Balancs Polarization agnda sttr is mor inflation-tolrant (th uppr part of Figur ). At highr lvls of polarization, in fact, th lvrag of th agnda sttr is almost compltl Not: At Polarization = 0, ==3. Incrasing polarization is man-prsrving (.g., at polarization = 3, =4.5 and =.5). Mor and lss inflation-tolrant rfrs to whthr is lss than or gratr than. Th shock paramtr c = 3, and dsird output *=. Not that th simulation is conductd ovr thos rangs of polarization whr all cass hav positiv proailit. Whn th xcutiv is mor inflation-tolrant, th proailit of Cas IV occurring coms ngativ whn polarization xcds.6. attnuatd: whn polarization quals.6, xpctd inflation quals 3.09, compard to thr in th simpl argaining cas. Th introduction of an indpndnt cntral ank Th forgoing argumnt shows that, rlativ to th cas whr th xcutiv is th sol dcision makr, chcks and alancs do not incras xpctd inflation significantl whn th xcutiv is mor inflation-avrs, and th do rduc it significantl whn th xcutiv is lss

15 inflation-avrs. This sction valuats th contriution that an indpndnt cntral ank can mak in ach cas. Th argumnt that inflation-avrs cntral ankrs can rduc inflation rlis on th assumption that dlgation of montar polic is difficult to rvrs. Two argumnts ar frquntl usd to justif this assumption. On is that political actors ar som xognous cost whn th ovrrid a cntral ank (as in Jnsn, 997). In ordr for cntral ank indpndnc to improv crdiilit rlativ to discrtionar montar polic, howvr, this cost must gratr than th cost a govrnmnt would fac if it rngd on a polic announcmnt in th asnc of dlgation. A scond argumnt is that cntral ank indpndnc might protctd a lgal stipulation that th agrmnt of mor vto plars is rquird to rvrs dlgation than to chang discrtionar montar polic. So, for xampl, th agrmnt to dlgat is changd onl if oth th lgislatur and xcutiv agr, whil montar polic in th asnc of dlgation could changd th xcutiv alon. In practic, howvr, as footnot (4) suggsts arlir, vn in th asnc of dlgation th lgislatur is likl to influnc discrtionar montar polic. Th modl prsntd aov offrs a third xplanation of wh lgal cntral ank indpndnc might rduc th inflation ias, vn if nithr of th prvious conditions hold. Bcaus th indpndnt cntral ank has agnda control, it can propos an inflation outcom, aftr th ralization of th shock, in such a wa that th lss inflation-tolrant political actor is no wors off than if th cntral ank's dcision wr ovrturnd and th two political dcision makrs wr rquird to agr on an altrnativ. To assss th contriution of th cntral ank undr ths circumstancs, w uild on th arlir modl and assum that pric sttrs stalish long-trm contracts, a shock occurs, th 3

16 cntral ank dtrmins an inflation polic, th two political actors dtrmin whthr to accpt th cntral ank s polic and, if th ovrturn it, th thn agr on an altrnativ polic. W assum that th political actors cannot ind thmslvs to an particular inflation polic until th first ovrturn th cntral ank s polic. 0 Thrfor, th polic that prvails should th rvok th cntral ank s indpndnc is prcisl th polic that would hav n institutd undr pur chcks and alancs (or CH in th discussion that follows). Th cntral ankr s loss function is () ( t t t t = ) an th cntral ank is mor inflation-avrs than ithr of th political actors ( <, ). Th cntral ank s prfrrd inflation polic is: () = ( ) W assum that th ank is sufficintl inflation-avrs that it alwas proposs th lowst inflation altrnativ that is th sam distanc from th most inflation-avrs political actor s prfrrd outcom as CH ( = = CH,whn <, and CH othrwis). That is, thr is no occasion whn its own prfrrd inflation outcom is actuall gratr than th outcom chosn using this rul. Givn this rul, th cntral ank will alwas propos an inflation outcom lss than or qual to CH and is nvr ovrriddn. Th cntral ank maks its polic proposal aftr th suppl shock is ralizd; dpnding on th siz of th suppl shock, and as for, CH can tak on on of four possil valus. 0 Ovrturning th cntral ank polic tpicall rquirs modifing th lgislation govrning cntral ank indpndnc; it is implausil to xpct that a conjunctural modification of montar polic would mddd in such lgislation. 4

17 Knowing that th cntral ank's dcision dpnds on th ralization of th shock, and that th cntral ank will alwas slct an ovrrid-proof inflation outcom, privat actors solv for xpctd inflation using quation (3), whn <. This is th sam as quation (9), with th diffrnc that th cntral ank rathr than th xcutiv has agnda control so that th anticipatd inflation outcoms undr ach cas ar diffrnt and dtrmind =. CH ( ˆ ˆ ) ( ) (3) = q q q3 ( ( ) ˆ ) ˆ 4 q Th trm 3 4 is xpctd inflation in th prsnc of a cntral ank. Th inflation outcoms associatd with ach of th four proailitis, qi, ar th ovrrid-proof policis chosn th cntral ank. So, for xampl, if th shock is such that Cas I is ralizd, < <, CH = caus if th cntral ank wr ovrturnd, th xcutiv would propos and th gislatur would accpt th xcutiv's prfrrd inflation outcom. Knowing this, th cntral ank chooss =, and th inflation polic in th vnt of Cas I is thrfor CH ˆ ( ). In Cas II, th inflation outcom in th vnt of an ovrrid of th cntral ank's proposal is th dfault outcom, or CH =, so that th cntral ank proposs = ( ) CH =. ˆ If th xcutiv th agnda-sttr is mor tolrant of inflation than th gislatur (<), th cntral ank thn sts polic such that th gislatur has no incntiv to agr to 5

18 rvrs th cntral ank. In this cas, th cass rmain th sam, ut th inflation polic chosn in ach cas th cntral ank chang, so that privat actors solv ( ˆ ) (4) = q ˆ ( ) q q ( ˆ 3 q4 4 ). Th solutions to quations (3) and (4) ar th privat actors calculations of xpctd inflation whn th agnda sttr is mor or lss inflation-avrs. Th ar drivd in Annx 3, and givn quations A.4 and A.5. xpctd Inflation Figur : Th ffct on xpctd inflation of cntral ank indpndnc Polarization Not: For paramtr valus and dfinitions, s Figur. xcutiv mor inflation-tolrant Chcks and Balancs With th cntral ank xcutiv lss inflation-tolrant Chcks and Balancs With th cntral ank Onc again, using numrical simulations to gnrat comparativ statics, w can addrss th scond main qustion of th papr: how dos th inflation ias with chcks and alancs and dlgation compar with that undr othr institutional arrangmnts? Figur illustrats svral 6

19 important prdictions of th modl on th impact of an indpndnt cntral ank rlativ to chcks and alancs without a cntral ank. First, xpctd inflation is alwas lowr undr chcks and alancs with a cntral ank whn compard to chcks and alancs and no cntral ank. Scond, th ffct of a cntral ank is most pronouncd whn th agnda sttr is mor tolrant of inflation and polarization is high th top and ottom lins in Figur. It might sm countr-intuitiv that xpctd inflation undr th institutional comination of chcks and alancs, a cntral ank, and an inflation-tolrant xcutiv is actuall lowr than undr th comination of chcks and alancs, a cntral ank, and an inflation-avrs xcutiv. This rsult drivs from th fact that th lvrag of th cntral ankr as agnda sttr dpnds ntirl on what th most inflation-avrs dcision makr can achiv undr pur chcks and alancs. Whn this dcision makr is th xcutiv and has agnda control undr pur chcks and alancs, sh can achiv an outcom much closr to hr prfrrd inflation outcom than if th inflation-avrs dcision makr is th lgislatur and dos not xrcis agnda control. Th furthr th chcks and alancs outcom, CH, from th prfrrd outcom of th inflation-avrs dcision makr, th lowr th inflation that th cntral ank can propos. Hnc, th cntral ank has th most influnc whn th agnda sttr, undr chcks and alancs, is most tolrant of inflation. 7

20 4. Tsting th hpothss Th modl undrlins th importanc of taking political institutions and prfrncs into account whn xamining th impact of administrativ arrangmnts such as cntral ank indpndnc (or judicial indpndnc, or th impact of rgulator agncis on firm dcisions). W can tst thr of th prdictions that mrg from th forgoing analsis. ) Th prsnc of a lgall indpndnt cntral ank should hav a ngativ ffct on inflation onl in th prsnc of chcks and alancs. ) Political intrfrnc, such as rplacmnt of cntral ank govrnors, is lss likl whn chcks and alancs ar prsnt. 3) Th prsnc of a lgall indpndnt cntral ank has a mor ngativ ffct on inflation whn diffrnt ranchs of govrnmnt hav divrgnt prfrncs ovr inflation. Th modl suggsts othr hpothss, rlatd to th intraction of th agnda sttr and polarization. Th asnc of data on agnda sttrs across countris mans that tsts of ths hpothss must rsrvd for futur work. Th first hpothsis ars on an unrsolvd puzzl in mpirical work on cntral ank indpndnc. A numr of paprs hav found a statisticall significant rlationship twn lgal masurs of cntral ank indpndnc and inflation in advancd industrializd conomis. Howvr, this rlationship has not n found in sampls that includ oth dvlopd and dvloping countris (Cukirman, W, and Napti, 99). W conclud, in a sampl that includs oth dvloping and dvlopd countris, that lgal indpndnc can rduc inflation ias, ut that this dpnds on th lvl of chcks and alancs in a countr's political sstm. S for xampl Alsina and Summrs (993), Cukirman, W, and Napti (99) and Grilli, Masciandro and Tallini (99). ohmann (998), in a cas stud of Grman that includs tim-sris tsts, and Mosr (999), in an conomtric invstigation of 0 OCD countris, also ask how th ffct of lgal indpndnc varis with lvls of chcks and alancs. Mosr dos not invstigat th ffcts of chcks and alancs on th turnovr of cntral ank govrnors, th rol of polarization, or implications for dvloping countris. 8

21 Th scond hpothsis is rlvant to prvious studis of cntral ank indpndnc and inflation, which hav found that d facto masurs of indpndnc, such as th rat at which cntral ank govrnors ar rplacd, ar ngativl corrlatd with inflation, and that this rlationship holds for oth dvlopd and dvloping countris. Th vidnc that w prsnt low suggsts that political intrfrnc in cntral ank dcision making is mor difficult undr chcks and alancs. Finall, th mpirical rsults low dmonstrat that th intraction ffct of lgal indpndnc and chcks and alancs is significantl gratr in mor polarizd nvironmnts, consistnt with th third hpothsis. An additional implication of th modl is that, rgardlss of th idntit of th agnda sttr, whn dcision makrs ar not polarizd (th lft-hand sid of Figur ), chcks and alancs should hav littl impact on xpctd inflation. W find that chcks and alancs hav an insignificant ffct on inflation outcoms whn polarization is low and cntral anks ar asnt. Data As our prox for th inflation ias, w us th log of avrag lvls of inflation as our dpndnt varial. 3 Our masur of lgal cntral ank indpndnc was dvlopd Cukirman, W, and Napti (99), asd on sixtn diffrnt charactristics of cntral ank statuts such as th trm of offic for th govrnor, provisions for his or hr rplacmnt, limits on cntral ank lnding to govrnmnt, and procdurs for rsolution of conflicts twn cntral ank and govrnmnt. Th data for I covr 7 countris and ar rportd dcad 3 This is asd on consumr pric indx data from th IMF, Intrnational Financial Statistics. An altrnativ dpndnt varial usd Cukirman, W, and Napti (99) is a transformd rat of inflation /(). Th argu this ttr rprsnts th costs to privat agnts of holding mon alancs than dos th simpl rat of inflation,, and that it rducs th ffct of outlirs. W hav optd for log inflation in our rgrssions oth caus of th as of intrprtation of a smi-log modl and caus using log inflation rsults in data which ar much lss htroskdastic than whn using ithr th simpl or transformd rat of inflation. 9

22 ovr th four dcads from 950 to Th componnt of I which masurs ruls concrning th tnur of th cntral ank govrnor is also usd sparatl and is lald CO. Ths authors hav also dvlopd d facto masurs of indpndnc. Cukirman, W, and Napti (99) argu that high turnovr of cntral ank govrnors is indicativ of low indpndnc and show that th rat of turnovr is positivl and significantl corrlatd with inflation in a sampl including oth dvlopd and dvloping countris. This papr uss an improvd d facto masur of cntral ank indpndnc dvlopd Cukirman and W (995), which rprsnts th frqunc with which cntral ank govrnors ar rplacd in th six months following changs in govrnmnt. This masur, govrnor turnovr, is also positivl and significantl corrlatd with inflation. 5 With rspct to chcks and alancs in govrnmnt, on would idall lik to hav information on th numr of political actors who xrcis vto powr ovr montar polic, along with th inflation prfrncs of ths actors. Givn th paucit of cross-countr data in this ara, two prox varials ar usd that captur th institutional aspcts of chcks and alancs ut not th prfrncs of th actors. Th first is th indx of xcutiv constraints, dvlopd Gurr, Jaggrs, and Moor in th Polit III datast. Thir masur is asd on a sujctiv assssmnt of diffrnt countris ovr tim following a pr-spcifid mthodolog whr valus rang from on, "no rgular limitations on th xcutivs actions", to svn, whn groups such as th lgislatur hav "ffctiv authorit qual to or gratr than th xcutiv in most aras of activit". Th construction of 4 W us Cukirman, W, and Napti s wightd indx which th call VAW. Du to missing data th total numr of osrvations for this varial is 36 (s Tal II for a summar). Th four priods ar dividd as follows, , 960-7, 97-79, In a fw cass govrnor turnovr could not codd caus a countr did not xprinc a chang of govrnmnt during th priod. This rsults in th xclusion of onl 4 potntial osrvations from our Tal III rgrssions. govrnor turnovr is masurd in two tim priods and

23 xcutiv constraints has th advantag of considring not just whthr thr ar formal, constitutional limitations on xcutiv powr ut also whthr ths limits xist in practic. A scond, mor rcnt masur of chcks and alancs dvlopd Kfr (998) has th advantag of ing asd on ojctiv critria and of capturing aspcts of chcks and alancs not masurd xcutiv constraints, such as th xistnc of coalition govrnmnts, or dividd control of two chamrs in a icamral sstm. Th varial chcks is constructd asd on varials in a nw dataas of political institutions assmld Bck, Clark, Groff, Kfr, and Walsh (999). This data is availal for th last two dcads of our sampl (970-89). Th indx is asd on a formula which first counts th numr of vto plars, asd on whthr th xcutiv and lgislativ chamr(s) ar controlld diffrnt partis in prsidntial sstms and on th numr of partis in th govrnmnt coalition for parliamntar sstms (as dscrid in gratr dtail in Annx ). Th indx is thn modifid to tak account of th fact that crtain lctoral ruls (closd list vs. opn list) affct th cohsivnss of govrning coalitions. Sinc th ffcts of chcks and alancs hpothsizd in th modl ar likl to strongst at lowr lvls of chcks than at highr lvls, w us a log vrsion of chcks, log chck, in our rgrssions. 6 In ordr to tst th proposition rgarding polarization on would idall hav information on th inflation and output prfrncs of diffrnt political partis. This data is not availal. Instad, w us two masurs of polarization. On, political polarization, is takn from th dataas of political institutions (Bck, t al.). Th four largst partis and th xcutiv in ach countr wr scord according to whthr th data sourcs indicatd partis as having an conomic orintation that was lft, cntr or right. This information is usd to assss th maximum diffrnc twn thos ntitis that compris th chcks indicator xplaind arlir. This maximum constituts th political polarization masur.

24 Our scond masur of polarization is a socit-wid indicator. Th argumnt is simpl that whr socit at larg is mor polarizd, th rprsntativs of socit that ar slctd to th various ranchs of govrnmnt ar mor likl to polarizd as wll. Social polarization has n proxid in th cross-countr mpirical litratur data from Sullivan (99), th siz of th principal thno-linguistic group as a prcnt of th population. W divrg from th litratur transforming this varial in a wa that is thorticall mor consistnt with notions of polarization. 7 Thor suggsts that socitis ar most likl to hav polarizd prfrncs whn thr ar a fw quall sizd groups, as opposd to on dominant group or man smallr groups. Th varial social polarization is thrfor a transformation of th Sullivan masur to mor closl approximat this thortical rquirmnt. 8 Tal I: Summar statistics Varial No. os. man std. Dv. min. max. log inflation I CO Govrnor turnovr xcutiv constraints log chck Opnnss political polarization social polarization log GDP Othrwis this varial would giv as much wight to a chang from to vto plars as from 4 to 5; sinc our modl spaks to th first cas and is silnt aout th scond, th log formulation is mor appropriat. 7 Th pionring papr hr is astrl and vin (997). Unlik us, th assum a monotonic rlationship twn thnic fractionalization and social polarization. 8 This varial attains its maximum whn th largst thnic group rprsnts 50% of th population and its minimum whn th largst thnic group rprsnts ithr 0% or 00% of th population. Th formula is social polarization= (% shar largst group) (% shar largst group) whr data on thnic groups is usd from Sullivan (99). This approach ilds a varial that matchs th thortical rquirmnts of polarization outlind in stan and Ra (994).

25 W us on additional control varial, opnnss, masurd as imports of goods and srvics dividd GDP (Intrnational Financial Statistics). This follows Romr (993), who argus that as imports incras as a shar of total consumption, polic makrs hav lss of an x post incntiv to inflat. Sinc th cntral ank indpndnc varial is onl availal dcad, othr controls, such as GDP growth, or trms of trad movmnts, ar prcludd. Howvr, w follow Cukirman, W, and Napti (99) and includ dcad dumm varials to control for unosrvd charactristics spcific to ach tim priod. Tsting proposition : chcks and alancs and cntral ank indpndnc In ordr to xamin whthr lgal cntral ank indpndnc has a strongr ngativ impact on inflation in countris with chcks and alancs, w us a modl with intraction trms that allows th marginal ffct of cntral ank indpndnc on inflation to var with th xtnt of chcks and alancs. Th gnral form of rgrssions -4 in Tal II (dcad dummis omittd) is shown in quation 5. (5) log inflation = a I chcks var. 3 (chcks var.*i) 4opnnss Th intraction trm is prdictd to hav a ngativ cofficint. Th nt ffct of cntral ank indpndnc, givn 3*(chcks varial), should to rduc inflation onl at high lvls of chcks and alancs. Tal II rports th rsults of four OS rgrssions. Th thortical analsis dmonstrats that, undr a rang of circumstancs, th mr prsnc of chcks and alancs can gnrat a lowr inflation ias. Rgrssions and provid support for this argumnt: th cofficints on xcutiv constraints and on log chck ar ngativ and significant. As in prvious rsarch, lgal cntral ank indpndnc has no significant impact on inflation whn it ntrs linarl, and opnnss is significantl and ngativl corrlatd with inflation. 3

26 Rgrssions 3 and 4 tst our first hpothsis, intracting lgal cntral ank indpndnc with thr diffrnt masurs of chcks and alancs. Th intraction trm is ngativ and significant, as prdictd, in oth cass. Th comind ffct of an incras in cntral ank indpndnc (taking into account oth th linar trm I and th intraction trm) is ngativ in oth rgrssions at high lvls of chcks and alancs. Tal II: Chcks and alancs, cntral ank indpndnc, and inflation dpvar: log inflation () () (3) (4) Constant -.6 (0.7) (0.33) -3.5 (0.4) -.7 (0.63) I -0.9 (0.44) 0. (0.64) 3.4 (.30) 3.48 (.8) opnnss -.5 (0.6) -.7 (0.8) -.7 (0.6) -. (0.9) xcutiv constraints -0. (0.03) 0.08 (0.06) I * xc. constraints (0.0) log chck (0.) 0.47 (0.53) I * log chck -3.6 (.48) R N p-valu for F stat. p<0.0 P<0.0 p<0.0 OS with Whit's htroskdastic consistnt standard rrors rportd in parnthss. Priod dummis not rportd. Mor concrtl, in a parliamntar sstm with a thr part govrning coalition (log chck=.6), a on standard dviation incras in lgal cntral ank indpndnc would prdictd to rduc annual avrag inflation approximatl 0 prcnt. 9 In contrast, in a parliamntar sstm with a singl part majorit (log chck=.), th prdictd chang in inflation would clos to zro (0. prcnt highr than othrwis). This suggsts an xplanation for 4

27 Cukirman, W, and Napti's finding that I is significantl and ngativl corrlatd with inflation in advancd industrial countris ut not in dvloping countris: dvloping countris, on avrag, hav lowr lvls of chcks and alancs. Tsting proposition : chcks and alancs and political influnc on cntral anks Whil our rsults show that lgal cntral ank indpndnc is prdictd to hav a mor ngativ ffct on inflation at high lvls of chcks and alancs, our modl also has implications for d facto masurs of cntral ank indpndnc, such as th frqunc with which cntral ank govrnors ar rplacd following changs in govrnmnt (govrnor turnovr). Rplacmnt of govrnors should mor difficult whn a cntral ank's statuts offr tnur guarants and whn chcks and alancs ar prsnt. In th asnc of chcks and alancs, lgal protctions of tnur ar asir to modif and thrfor lss ffctiv in constraining political actors. This argus in favor of stimating a sstm of quations whr inflation is a function of govrnor turnovr, and govrnor turnovr is itslf ndognous to lgal protctions of tnur and chcks and alancs. quations 6 and 7 low dscri such a sstm (with priod dummis omittd and rcalling that CO masurs lgal protction of tnur). A varial for chcks and alancs is includd in oth quations, caus our modl prdicts that chcks ma hav a dirct ffct on inflation as wll as an indirct ffct (via cntral ank indpndnc). Th varial CO, on th othr hand, should onl influnc inflation through its ffct on govrnor turnovr. (6) govrnor turnovr = a CO chcks var 3chcks var * CO (7) log inflation = a 4govrnor turnovr 5opnnss 6 chcks var 9 That is, for xampl, a drop in inflation from 0 prcnt pr ar to 8 prcnt pr ar. 5

28 Tal III rports rsults from Two Stag ast Squars stimation of ths quations. Th k rsult is actuall th first quation in ach of th two modls (on modl for ach masur of chcks), which tsts proposition, that turnovr of cntral ank govrnors is dtrmind th intractiv ffct of chcks and alancs and laws protcting th tnur of govrnors. Th intraction trm in our stimations of quation (6) has th xpctd ngativ sign in ach cas. Th highr th lvl of chcks and alancs, th mor ngativ th prdictd political influnc on th cntral ank. In th cas of th sstm stimatd using log chck, th intraction trm is significant at th 5 prcnt lvl whil th intraction trm in th sstm stimatd with xcutiv constraints has th xpctd sign ut is not statisticall significant. Th scond quation in ach modl ars on th finding in prior rsarch that lgal cntral ank indpndnc is an insignificant dtrminant of inflation, ut govrnor turnovr a significant dtrminant, in sampls that includ oth rich and poor countris. Th discussion of th first proposition xplains on part of this anomal: th insignificanc of lgal cntral ank indpndnc rsults from th omission of political institutions. Th scond quations in Tal III suggst an institutional xplanation for th othr part of th anomal, as wll. Th valu of turnovr prdictd from political and lgal institutions has a positiv influnc on inflation, although th cofficints on govrnor turnovr ar not significant at convntional lvls. Th sustantiv rsults ar also consistnt with thos from th tst of proposition. In a parliamntar sstm with a ruling coalition of thr partis (log chck=.6), a on standard dviation incras in CO is prdictd to chang govrnor turnovr -0.07, translating into a dcras in annual avrag inflation of 3 prcnt. In contrast, in a similar sstm with a singl part govrnmnt (log chck=.), a on standard dviation incras in CO has ssntiall no ffct on turnovr (0.003) or inflation (0.5 prcnt). 6

29 Tal III: Formal indpndnc, d facto indpndnc and chcks and alancs Modl Modl Dp. Varial turnovr ln(inflation) turnovr ln(inflation) Constant 0.5 (0.6) (.7) Govrnor turnovr.95 (.5) Opnnss (.0) CO 0.6 (0.8) xc. Constraints (0.0) CO * xc. Constraints (0.05) -0.0 (0.09) 0.7 (0.) 0.85 (0.4) log chck 0.09 (0.9) CO * log chck (0.39) -. (0.80).79 (.6) -.6 (0.58) -.05 (0.35) R N Pro>Chi modl p<0.0 P<0.0 P<0.0 p<0.0 Two-stag last squars; th first stag (not rportd hr) is turnovr as a function of opnnss, CO, CO*chcks varial, and th chcks varial. Priod dummis not rportd. Tsting proposition 3: polarization and cntral ank indpndnc Chcks and alancs should mattr most whn thr ar prfrnc diffrncs among various political vto plars. Our modl prdicts that th highr th lvl of polarization twn vto plars in govrnmnt (with rspct to inflation and output prfrncs), th gratr th impact of cntral ank indpndnc and chcks and alancs on inflation. 0 To tst this proposition, w r-run th rgrssions from Tal II, splitting th sampl twn high 7

30 polarization and low polarization countr-dcads (asd on th mdian valu of our two polarization varials social polarization (in Tal IV) and political polarization (in Tal V). Th first notal rsult in th two tals is that, as w would prdict from Figur, th prsnc of chcks and alancs maks littl diffrnc in xpctd inflation at low lvls of polarization and at low lvls of cntral ank indpndnc. At highr lvls of polarization, th ffct of chcks and alancs dpnds on dtails of th agnda-stting institutions aout which w hav no cross-countr data. Th rsults ar also consistnt with th prdictions of proposition 3. For oth masurs of polarization and oth masurs of chcks and alancs, th intraction trms I * chcks ar of th largst magnitud, ngativ and highl significant in th high polarization su-sampls. In th low polarization su-sampls, th intraction trms ar gnrall small and not statisticall significant. Th xcption is th intraction trm using xcutiv constraints in th low polarization su-sampl of Tal V. Howvr, although it is ngativ and significant, it is nonthlss smallr in magnitud than th cofficint on th intraction trm in th high polarization susampl. 0 Ths ffcts should var with th idntit of th agnda sttr, which w cannot captur in our mpirical tsts. Polarization can also hav othr ffcts that w do not modl. Alsina and Gatti (995) argu that cntral ank indpndnc will rduc varianc of output and of inflation in countris with polarization across govrnmnts minimizing partisan usinss ccls. 8

31 Tal IV: Social polarization, cntral ank indpndnc, and chcks and alancs dpvar: log infl. low pol high pol ow pol high pol constant -.7 (.00) I -.6 (.48) opnnss -.0 (0.90) xc. constraints -0.0 (0.4) I * xc. constraints 0.04 (0.37).35 (0.3) 5.67 (.73) ) 0.9 (0.08) -.04 (0.8) (.4) -0.0 (3.64) -.6 (0.79) log chck -0.7 (.) I * log chck -0.3 (3.) -.40 (0.66) 4.66 (.98) (0.6) 0. (0.5) -.94 (.45) R N p-valu for F stat. p<0.0 p<0.0 p=0. p<0.0 Tal V: Political polarization, cntral ank indpndnc, and chcks and alancs dpvar: log infl. low pol high pol ow pol high pol I 4.97 (.84) opnnss -.6 (0.30) xc. constraints 0.7 (0.) I * xc. constraints (0.33) 0.3 (5.00) -.30 (0.7) 0.4 (0.3) -.57 (0.73).0 (3.4) -. (0.3) log chck (.0) I * log chck -0.0 (3.) 4.65 (.66) -.5 (0.86).05 (0.7) (.88) R N p-valu for F stat. p<.00 p=0.0 p<.00 P=0.06 Not: OS with Whit's htroskdastic consistnt standard rrors rportd in parnthss. Priod dummis not rportd. It was not possil to split th sampls vnl in Tal V caus political polarization had a valu for zro for mor than half of th osrvations. Roustnss Th vidnc prsntd in this sction indicats that our rsults ar not drivn srial corrlation, th ndognit of lgal cntral ank indpndnc to inflation or laggd inflation, omittd varials, including political instailit, nor outlirs. 9

32 Rsults of agrang multiplir tsts suggst srial corrlation of th rror trms might hav ld to inconsistnt stimats of standard rrors in th tsts of th first two propositions. Howvr, th rsults in Tals II and III ar roust to controls for srial corrlation. In particular, rgrssions 3 and 4 of Tal II ar roust to th inclusion of a laggd dpndnt varial. 3 Similarl, th introduction of a laggd inflation varial in th tsts of proposition two had littl ffct on th rsults in Tal III. Sinc th introduction of a laggd dpndnt varial significantl rducs sampl siz, w hav prfrrd to prsnt rsults from th original spcification in Tals III and IV. It is possil that countris adopt lgall indpndnt cntral anks in rspons to outs of high inflation, prhaps proddd th intrnational financial communit, making I ndognous to laggd valus of inflation, a scond possil sourc of inaccurac in our rsults. Thr ar oth thortical and mpirical rsponss to this possiilit. Thorticall, th modl and th tsts rportd in Tal II ar valid vn if th adoption of cntral ank indpndnc is motivatd high outs of inflation. If past inflation lads countris to adopt cntral ank indpndnc, w prdict that th ffcts of this would diffrnt in high and low chcks countris. In low chcks countris, this procss would lad to a positiv association twn inflation and cntral ank indpndnc, sinc privat actors would not viw indpndnc as crdil and inflation prsistnc would thrfor not rvrsd. In high chcks countris, on Th null of no autocorrlation was rjctd at th p<.00 for ach of th rgrssions. Our prfrrd mthods of addrssing th prolm (such as using Nw-Wst standard rrors) ar infasil sinc th ild inconsistnt rsults in data sts with small numrs of tim priods rlativ to cross-sction osrvations. 3 P-valus for th cofficints on th intraction trms in th chcks and xcutiv constraints spcifications oth rmaind significant at th 0% lvl (at p=0.067 and p=0.068 rspctivl). agrang multiplir tsts following th inclusion of a laggd dpndnt varial could not rjct th null hpothsis of no autocorrlation. W also transformd our data st into cross-sction varials ovr th whol tim priod. If srial corrlation wr rsponsil for th rsults w rport, ths rsults should disappar in cross-sction rgrssions. Rsults for xcutiv constraints rmaind significant, and rsults using log chcks rtaind th corrct sign. 30

33 th othr hand, th adoption of an indpndnt cntral ank in rspons to past inflation would rduc inflation xpctations. mpiricall, w find littl vidnc that cntral ank indpndnc is ndognous to laggd inflation, in an cas. I is not Grangr-causd laggd inflation. Similarl, th CO componnt of I, usd in th tsts of proposition two to captur lgal provisions rgarding govrnor tnur, is not Grangr-causd laggd inflation. Grangr tsts do suggst that d facto cntral ank indpndnc as masurd govrnor turnovr is significantl corrlatd with laggd inflation. Howvr, whn w stimat th rgrssions in Tal III including laggd inflation as a right-hand varial in th turnovr rgrssions, th rsults ar consistnt with th initial rgrssions, although th sampl siz is significantl rducd. 4 It is also possil that I or CO ar ndognous to contmporar inflation, sinc th four priods ncompassd th data ar ach long, as much as ars. Howvr, whn w instrumnt for I with laggd I in th tsts in Tal II, Hausman spcification tsts do not rjct th original OS stimats. 5 Rsults ar similar whn w instrumnt for CO with laggd CO in th Tal III turnovr rgrssions which tst proposition. 6 Th influnc of omittd varials on cntral ank indpndnc, chcks and alancs and inflation is a third possil sourc of spurious rsults in th rgrssions prsntd arlir. Howvr, our rsults ar roust to th inclusion of additional varials suggstd th litratur. 4 In th chck spcification in Tal III, th intraction trm in th turnovr rgrssions actuall incrasd slightl in magnitud and cam mor significant with cofficint 0.80 and standard rror (0.38). In th xcutiv constraints spcification th intraction trm rmaind ngativ ut was not significant (0.055). 5 Th null that th diffrncs twn th paramtr stimats from an OS stimation of rgrssions 3 and 4 from Tal III and an instrumntal varials stimation ar not significant (and thus that th OS stimats wr consistnt) could not rjctd in an of th thr cass. Ths tsts also involvd instrumnting for th intraction trm I x chcks var. P-valus for th tsts in th chck and xcutiv constraints spcifications wr p=0.97 and p>