Central Bank Independence and Inflation: An Empirical Approach

Abstract

Central bank independence is defined as the autonomy of central banks from politically controlled and motivated branches of the government and the ability to set independently the goals of monetary policy. This paper investigates a relationship between legal independence of central banks and inflation for one hundred and seventeen countries in a period from 1970 to 2010 using a two-way fixed effect model. The paper finds a negative relationship between these two variables, after controlling for several other macroeconomic and policy indicators. A comprehensive investigation further reveals that the relation between central bank independence and inflation varies with the income level of the country. This paper concludes that neither too rich nor too poor countries can benefit from a legal reform of a central bank. The study also identifies that central bank autonomy matters more after 1990, compared to the previous twenty years. Broad money growth and financial openness of a country are found to be more robust determinants of inflation, as compared to the legal independence of the central bank.