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    Abramowicz Thesis

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    Jeganraaj Periasamy
    This document is a thesis submitted by Michael B. Abramowicz to Amherst College in partial fulfillment of the requirements for a Bachelor of Arts degree with honors in economics. It examines the theoretical and empirical relationship between central bank independence and output stabilization. The thesis acknowledges those who provided guidance and support during its development, including the faculty advisor and others who provided advice, references, and distractions from work. It contains an introduction outlining the issues to be examined, followed by planned chapters on the time-inconsistency problem in monetary policy, a macroeconomic model of central bank independence, previous studies on the topic, measures of stabilization performance and shock severity, results of testing those measures, and conclusions.

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    Abramowicz Thesis

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    Jeganraaj Periasamy
    230 views336 pages
    This document is a thesis submitted by Michael B. Abramowicz to Amherst College in partial fulfillment of the requirements for a Bachelor of Arts degree with honors in economics. It examines the theoretical and empirical relationship between central bank independence and output stabilization. The thesis acknowledges those who provided guidance and support during its development, including the faculty advisor and others who provided advice, references, and distractions from work. It contains an introduction outlining the issues to be examined, followed by planned chapters on the time-inconsistency problem in monetary policy, a macroeconomic model of central bank independence, previous studies on the topic, measures of stabilization performance and shock severity, results of testing those measures, and conclusions.

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    This document is a thesis submitted by Michael B. Abramowicz to Amherst College in partial fulfillment of the requirements for a Bachelor of Arts degree with honors in economics. It examines the theoretical and empirical relationship between central bank independence and output stabilization. The thesis acknowledges those who provided guidance and support during its development, including the faculty advisor and others who provided advice, references, and distractions from work. It contains an introduction outlining the issues to be examined, followed by planned chapters on the time-inconsistency problem in monetary policy, a macroeconomic model of central bank independence, previous studies on the topic, measures of stabilization performance and shock severity, results of testing those measures, and conclusions.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOC, PDF, TXT or read online from Scribd
    Flag for inappropriate content
    Download as doc, pdf, or txt
    230 views336 pages

    Abramowicz Thesis

    Uploaded by

    Jeganraaj Periasamy
    This document is a thesis submitted by Michael B. Abramowicz to Amherst College in partial fulfillment of the requirements for a Bachelor of Arts degree with honors in economics. It examines the theoretical and empirical relationship between central bank independence and output stabilization. The thesis acknowledges those who provided guidance and support during its development, including the faculty advisor and others who provided advice, references, and distractions from work. It contains an introduction outlining the issues to be examined, followed by planned chapters on the time-inconsistency problem in monetary policy, a macroeconomic model of central bank independence, previous studies on the topic, measures of stabilization performance and shock severity, results of testing those measures, and conclusions.

    Copyright:

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    of 336

    SubmittedtotheDepartmentofEconomicsofAmherstCollegeinpartial

    fulfillmentoftherequirementsforthedegreeofBachelorofArtswithhonors.
    April18,1994
    CENTRALBANKINDEPENDENCE
    ANDOUTPUTSTABILIZATION
    byMichaelB.Abramowicz
    FacultyAdvisor:GeoffreyR.Woglom
    Acknowledgments
    Withoutthepatience,goodhumor,energyandideasofProfessor
    GeoffreyWoglom,developmentofthisthesiswouldnothavebeen
    theintellectuallyexcitingexperiencethatitbecame.Andso,Ithank
    himfirstandforemost.
    ThisthesisalsorequiredthebackgroundineconomicsthatIobtained
    overmyyearsatAmherst.Andso,Imustcreditthosewhotaught
    me,ProfessorDanielBarbezat,ProfessorWalterNicholson,Professor
    XiaonianXuandProfessorBethYarbrough.
    Severalindividualsprovidedspecificadvicethathelpedmealong.I
    thankProfessorRalphBealsandProfessorFrankWesthofffortipson
    datacollection.Forprovidingmathematicalreferences,Ithank
    ProfessorNortonStarrandJessicaWolpaw94.Finally,foranswering
    myqueriesandorderingcountlessarticlesnotavailableatAmherst,I
    thankthereferencestaffoftheFrostLibrary.
    Imighthavefinishedconsiderablyearlierhaditnotbeenforthe
    distractionsoffriends.Forsuchpleasures,Iparticularlythankmy
    suitemates,TaraGleason94andLauraSchulz94,andmyformer
    comradesatTheAmherstStudent,whoalwaysinsistedthatwemix
    ourbusinesswithpleasure.
    Last,butnotleast,Ithankmyfamilyfortheirlove,andmyparentsin
    particular,forbothencouragingandfundingmyAmhersteducation.
    Idedicatethisthesistothememoryofmygrandfather,Samuel
    Kaufman,towhomIcannotdojusticewithmerewords.Imisshim
    andlovehimalways.
    TableofContents
    Introduction
    ........................................................................................
    5
    TheTimeInconsistencyProblem
    ........................................................................................
    8
    EndogenizingCentralBankIndependence
    ........................................................................................
    52
    StudiesofCentralBankIndependence
    ........................................................................................
    161
    MeasuringStabilizationPerformance
    ........................................................................................
    194
    ResultsandConclusions
    ........................................................................................
    321
    WorksCited
    ........................................................................................
    334
    Chapter1:Introduction
    CentralbankindependencehasbecomeasinequanonofEuropean
    MonetaryUnion,evenascriticsintheUnitedStatesurgesomeretrenchmentof
    FederalReserveindependence.ObserverssuchasAlesinaandGrilli(1992)have
    engagedincarefulanalysisofwhethertheproposedEuropeanCentralBankwill
    beindependent,withtheassumptionthatindependenceisindeedthegoal.The
    proposedconstitutionoftheBankincludesaclearmandateforpricestability,
    andspecifiesthatmembersoftheBanksboardservenonrenewableeightyear
    terms,thuspresumablyfreefrompoliticalinfluence.Suchinfluenceisanathema
    totheMaastrichtaccord.AsFratianni,vonHagen,andWaller(1992)note,
    Article107requiresthatmembercountriesnoteventrytoinfluencethebank.In
    theUnitedStates,meanwhile,abillintroducedinCongresswouldrequireFed
    officialstomeetwiththepresidentseconomicadvisers,andwouldgivethe
    GeneralAccountingOfficetheauthoritytoaudittheFed.Othershavecalledfor
    producingandreleasingvideotapesofFederalReservemeetings,removingthe
    veilofsecrecythatmonetarypolicymakersenjoy.Thosehopingtoreinincentral
    bankindependencehaveencounteredstaunchopposition.Itisclear,however,
    thattheunmitigatedenthusiasmamongeconomistsforcentralbank
    independencethattheEuropeanCentralBankconstitutionreflectsisnotso
    prevalentinpoliticalcircles.
    Thedraftersofaconstitutionforacentralbankfaceavarietyofdecisions
    aboutitsinstitutionaldesign.Shouldthebankconductmonetarypolicyatthe
    whimofpoliticalauthorities,orshoulditsgovernorsbeunaccountabletothe
    government?Shouldabankfollowrigidrulesinsettinginflationtargets,or
    shouldbankersbeallowedtousetheirdiscretionateachtimeperiod?
    Developingsatisfactoryanswerstosuchqueriesrequiresfirst,anunderstanding
    ofthetheoreticalunderpinningsofinteractionsbetweengovernments,central
    bankersandothereconomicagents,andsecond,empiricalexaminationofthe
    consequencesofcentralbankindependence.Acriticalquestionthatadesignerof
    anyeconomicinstitutionfacesiswhetherinstitutionaldesignhasimplications
    forrealeconomicperformance.Anaffirmativeresponsestillleavesunanswered
    whicheconomicgoalstheinstitutionshouldtargetandhowtomaximize
    performancewithrespecttothosegoals.Caninstitutionalactivismimproveon
    laissezfaire,orareinstitutionaleffortstocorrectmarketimperfectionsboundto
    worsenexistingproblems?
    Thispaperexploresthetheoreticalandempiricalrelationshipbetween
    centralbankindependenceandoneaspectofperformance:thestabilizationof
    theoutputlevel.Thepaperproceedsasfollows.Chapter2surveystheliterature
    thatdiscussestheimplicationsofthetimeinconsistencyproblemfortheconduct
    ofmonetarypolicy.Thisliteratureexploresthetradeoffthatacentralbanker
    facesbetweenearningreputationandusingdiscretiontoachievebettershortrun
    economicperformance.Chapter3developsamacroeconomicmodelthat
    endogenizescentralbankindependence.Countriesareassumedtofacedemand
    shocksofdifferentialseverity,andcountrieswithrelativelydependentcentral
    banksareassumedtobebestabletomitigateshocks.Giventhisbenignviewof
    centralbankintervention,themodelpredictsmorecentralbankindependencein
    thosecountrieswithfewershocks.Chapter4examinespreviousstudiesofthe
    relationshipbetweencentralbankindependenceandrealeconomicperformance,
    particularlyAlesinaandSummers(1993).ThemacroeconomicmodelofChapter
    3suggeststhatoneofAlesinaandSummerstestscouldproducebiasedresults.
    Inparticular,resultsthatsuggestnorelationshipbetweencentralbank
    independenceandthevariabilityofoutputarequestioned.Chapter5develops
    andreportsindicatorsoftheeffectivenessofstabilizationpolicyandtheseverity
    ofshocksinindustrialcountries.Theseveralmeasuresofstabilizationpolicy
    effectivenessaredesignedtotakeintoaccountthecriticismsofChapter4.
    Chapter6reportstheresultsofthesetestsandconcludes.Theevidencedoesnot
    supportthepredictionofChapter3thatcentralbankindependenceisrelatedto
    shockincidence.However,thedatastronglysuggestthatcountrieswith
    independentcentralbankshavethebeststabilizationperformance.This
    conclusionisconsistentwiththemodelofChapter3ifcentralbanksattemptsat
    stabilizingshocksinfactcreatenewshocksormakeexistingshocksworse.
    Chapter2:TheTimeInconsistencyProblem
    Theonlywaytogetridofatemptationistoyieldtoit.
    OscarWilde
    Thischapterreviewstheliteraturesuggestingthataneconomic
    institution,inparticularacentralbank,maybebestabletoprovideforeconomic
    performancebyprecommittingtoacertaincourseofaction.Inparticular,
    discretiontoselecttheinflationrateateachtimeperiodratherthaninadvance
    mayalterexpectationsinsuchawayastoworsentradeoffsthecentralbanker
    faces.Forexample,thischaptershowshowinaoneperiodgamebetweena
    centralbankerandthepublic,thecentralbankermayseektolower
    unemploymentbelowitsnaturalratethroughhighinflation.Anticipatingthis,
    thepublicsetsinflationaryexpectationssohighthatthecentralbankerhasno
    incentivetoincreaseinflationabovetheexpectedlevel.Theliteraturesuggests
    thatinatwoperiodgame,reputationaleffectsmaylowertheincentivetocheat
    andthusindirectlythelevelofinflation.However,addinguncertaintytothe
    game,forexampleviaastochasticerrortomoneydemand,maysufficiently
    complicateitsoastomakealowinflationreputationalequilibriumimpossibleto
    achieveeveninaninfiniteperiodsetting.Societymaythusrequirean
    institutionalrestrainttoimproveontheresultfromnoncooperation.Sucha
    restraintmightcome,forexample,throughafixedexchangerate,orthrough
    electionofaconservativecentralbanker.Moresevererestraintslowerexpected
    andactualinflation,butattheexpenseoftheabilitytorespondtoeconomic
    disturbances.Theremainderofthischapterdiscussesinmoredetailthereasons
    thatarestraintmightbenecessaryandtheformsarestraintmighttake.
    Thefoundationforgametheoreticmodelsofcentralbankpolicyis
    KydlandandPrescotts(1977)argumentthatoptimalcontroltheorymaynot
    applytodynamiceconomicsystems.Optimalcontroltheorysuggeststhat
    policymakerscanachievethebestpossibleresultswhentheyactateachpointin
    timeinsuchawayastomaximizethesocialobjectivefunction.Indynamic
    systems,KydlandandPrescottwrite,Currentdecisionsofeconomicagents
    dependinpartupontheirexpectationsoffuturepolicyactions.(p.474)
    Considerafamiliarscenarioinwhichsocialwelfareismaximizedwhenno
    memberofsocietyengagesinriskybehavior.However,assumealsothatsocial
    welfareismaximizedifgiventhatindividualsdoengageinsuchbehaviorand
    areharmed,thengovernmenthelpsthem.Forexample,theriskybehaviorcould
    beinvestmentoffundsinasavingsandloanindangeroffailure.The
    governmentcanmitigatetheconsequencesofasavingsandloanfailureby
    reimbursingdepositors.
    Onewayforgovernmenttopreventindividualsfromengaginginrisky
    behaviorisforthegovernmenttopromisenottohelpthosewhosufferthe
    consequencesoftakingtherisks.Inthisexample,thecancellationoffederal
    depositinsurancewouldbeacommitmentnottoyieldtothetemptationtohelp
    failedsavingsandloansinvestors.Withsuchacommitment,individualshave
    anincentivetomonitordepositoryinstitutionsandrefrainfrominvestingin
    riskyones,thusbenefitingsocialwelfare.Thiscommitment,however,entailsa
    cost.Governmentwillbeunabletohelpifriskybehaviorresultsanywaywith
    adverseconsequences,suchasmassivesavingsandloanfailures.Acommitment
    isatoddswiththerecommendationofoptimalcontroltheory,sincethe
    commitmentpreventsgovernmentfromtakingthebestpathateachperiod.If
    thebenefitsofsuchcommitmentaregreaterthanthecosts,thentheexampleis
    oneinwhichoptimalcontroltheorydoesnotprovidethebestmodelforpolicy.
    Similarexamplesareeasytoconstruct.Aninstitutionaldesignthatallows
    governmenttomakecommitmentsnottoyieldtotemptationthuscanprovide
    betterresultsthanoneinwhichgovernmentisleftdiscretion.
    Criticaltoanunderstandingofthepolicymakerpublicdynamicarethe
    definitionsoftimeconsistency,credibility,andreputation.Anannouncedpolicy
    istimeinconsistentifthepolicymakerhasanincentivetorenegeonitlater.In
    thesavingsandloanexample,apolicynottoreimbursedepositorsoffailed
    savingsandloanswouldbetimeinconsistent,becausegivenfailures,the
    governmentwouldliketohelpdepositors.Apolicymakerearnsagood
    reputationbyfollowingthroughonpolicyannouncementsregardlessof
    consequence.Reputationcanmakepoliciesbecomemorecredible,becausethe
    policiesarepromulgatedbyanindividualwhohistoricallyhasremainedfaithful
    topolicyannouncements.Forexample,ifapresidentwithagoodreputation
    announcedthatinvestorsinfailedsavingsandloanswouldnotbereimbursed,
    thensuchapolicymightbecomecredible,eventhoughitistimeinconsistent.
    Thepolicymakerthusfacestwogoalsindeterminingwhethertoconformtopast
    policyproclamations.First,thepolicymakermustconsiderwhetherchanging
    policywouldprovidebetterresults.Second,evenifchangingpolicywould
    improvecurrenteconomicperformance,itmightmakesensetostandbyapast
    policytoearnreputationthatwouldenhancecredibilityandallowasmoother
    implementationofpolicyinthefuture.Whileastrongreputationcanmaketime
    inconsistentpoliciescredible,apolicymakermayneedtoimplementnoncredible
    policiestoimprovereputation.Policiesaretypicallynoncrediblewhentheydefy
    incentives,sosuchimplementationcanbecostly.
    KydlandandPrescottapplytheircritiqueofoptimalcontroltheorytothe
    centralbankerschiefdilemma,theinflationunemploymentproblem.The
    Phillipscurvesuggeststhatcentralbankerswishtocombatinflationandraise
    employmentabovethenaturallevel,butfaceatradeoff.Specifically,
    (2.1)

    u
    t

    ,
    where

    u
    t
    isunemploymentinperiod

    apositiveconstant,

    and

    theexpectedandactualratesofinflationinperiod

    ,and

    u
    n
    thenaturalrateofunemployment.Ifinflationissetequaltoexpectations,
    unemploymentisequaltothenaturalrate.However,theoptimalrateof
    unemploymentfromthepolicymakersperspective,

    ,maynotbeequaltothenaturalrate.Forexample,thegovernmentmayhave
    socialmobilityorequitygoalswhoseachievementwouldrequireunemployment
    tobebelowthenaturallevel.Thedifference

    ,ifpositive,representsasurpriseinflationinperiod

    thatlowers
    unemploymentbelowthenaturalrate.
    Consideraoneperiod,twoplayergame,inwhichthepublicsets

    justbeforeperiod

    andacentralbankersubsequentlysets

    .Thecentralbankercanattempttoreduceunemploymenttowardtheoptimal
    levelbytargetinginflationatalevelhigherthanexpected.Economicagents,
    however,understandthatthecentralbankerhasanincentivetoraiseinflation
    aboveexpectations,andthusset

    tosomepositivevalue.Ifexpectationsarerational,thepubliccanforeseethe
    levelsofinflationandoutputintheequilibriumthatresults.Thisrational
    expectationsequilibriumoccurswithasufficientlyhighlevelofinflationto
    guaranteethatthecentralbankerhasnoincentivetoattemptafurthersurprise
    inflation.Thecentralbankerthussets

    > 0
    .Effectively,thepublicandthecentralbankermustrespectivelydecidewhether
    toset

    or

    tozeroortoapositivevalue.Regardlessofwhichoptionthepublicchooses,the
    centralbankerbenefitsbysetting

    toapositivevalue.Becausethepublicsbeststrategyistodowhateveritthinks
    thecentralbankerwilldo
    1
    ,itsetsahigh

    .Theequalityofactualandexpectedinflationimplies

    u
    t

    ;thecentralbankersattempttolowerunemploymentisfruitless.Because
    neitherthecentralbankernoranyindividualinthepublichasanincentiveto
    changeitschoiceaftertheotherplayermakesitsstrategicselection,high
    inflationisaNashequilibrium.Sinceinflationandunemploymentwouldbe
    lowerifonlythecentralbankercouldcompelthepublictohavelowinflationary
    expectations,thisnoncooperativeequilibriumissuboptimal.Theimplicationof
    theKydlandPrescottanalysis,however,isthatprecommitmentprovidesan
    escapetothisunhappyconclusion.Ifthecentralbankcancrediblymakethe
    timeinconsistentpromisethatitwillset
    1
    ThisdistinguishesthegamedescribedfromtheclassicPrisonersDilemma.InthePrisoners
    Dilemma,eachprisonerbenefitsfromcheatingregardlessoftheactionsoftheotherprisoner.
    Here,thepublicwouldcooperateifitweretobelievethatthecentralbankwilltoo.

    0
    ,thepublicwillset

    0
    .Bygivingupontheunachievableunemploymentgoal,thecentralbanker
    achieveslowerinflation.
    Whyistherenoncooperationbetweenacentralbankerandthepublic
    whosewelfarethebankeristryingtomaximize?Thepublic,itmightseem,
    shouldset

    toalowvaluesothatthecentralbankercanachievesocialoutputgoals.The
    monolithicpublicsinflationexpectationsaretheresultofapublicgood
    problem.Whileindividualsmightlikesocietytoattainalowunemployment
    equilibrium,theirprimemotivationistoforecastinflationaccurately.All
    economicagentscouldbenefitbycooperativelysettingexpectedinflationtoa
    levelthatwillallowthecentralbankertoachieveanemploymenttarget,but
    suchcollectiveselfdeceptionisimpossible.Regardlessofhowotherspredict
    inflation,eachindividualeconomicagentwouldsufferfromanintentionally
    inaccurateexpectationofinflation.Theremaybenumerouswaystomotivatea
    relationshipbetweenindividualutilityandtheaccuracyofinflationexpectations.
    WhileChapter3providesonescenariothatexplainsthisrelationship,any
    groundsforacceptingthatinflationexpectationsarerationalaresufficientto
    assesstheKydlandPrescottgamemathematically.
    BarroandGordon(1983)solvefortheinflationratethatresultsintheone
    periodgame.BarroandGordonassumenoinformationalasymmetries;the
    publicknowsthatthecentralbankerwillchoosealevelofinflationthat
    minimizesthecostofinflationminusthebenefit,andunderstandsthebankers
    preferences.TheBarroGordonlossfunction
    2
    ,withnotationmodifiedfor
    consistencywiththispaper,is
    2
    Costsinlossfunctionsareexpressedaspositivenumbers,andbenefitsaspositive.Thus
    minimizationofthelossfunctionmaximizesbenefitsminuscosts.
    (2.2)

    L
    t

    2
    (

    )
    2
    (

    L
    t

    2
    (

    )
    2
    (

    )
    ,
    where

    a, b > 0
    areparametersoftheeconomy
    3
    ,and

    L
    t
    isthelossinperiod

    .Thefirsttermreflectsthecostsofinflation,andthesecond
    termreflectsthebenefitsofasurpriseinflationinreducingunemployment,asin
    Equation2.1.Underpurediscretion(i.e.discretionblindtoreputationaleffects),
    thecentralbankerminimizes

    L
    t
    withrespectto

    .Whenthecentralbankerperformsthisminimization,expectationsofinflation
    havealreadybeenset,so

    isaconstant,thereforewith

    0
    .Minimizationof

    L
    t
    withrespectto

    yields


    3
    Forsimplicity,assumethatthebparameterisaconstant.BarroandGordon,incontrast,define
    theparameterasarandomvariablewithafixedmeanandvariance.Thisallowsforthecentral
    bankerspreferencestochangeovertime.
    .Thuswithpurediscretion,thecentralbankerwillsetinflationatsomepositive
    value.Giventhatthecentralbankerwillsetinflationat


    ,thepublic,whichbenefitsfromaccurateexpectationsofinflation,makes
    decisionsbasedonanexpectedinflationrate


    .Regardlessoftheexpectedinflationrate,thecentralbankerhasnoincentiveto
    targetanyotherlevelofinflation.Themarginalbenefitofanincremental
    surpriseinflationabove


    ,abenefitwhichmanifestsitselfinthesecondtermofthesociallossfunction,
    preciselybalancesthemarginalcostinthefirsttermofthesociallossfunction.
    Apolicymakerwhocouldprecommittoalevelofinflationminimizes

    L
    t
    subjecttotheconstraint

    .Theresultis

    0
    ,whichBarroandGordondefinetobetheidealrule.(Thebarover

    isanotationalconventiontosignifytheresultsoffollowingarule.)Theideal
    solutionisthus

    0
    .Apolicyoffollowingthatruleistimeinconsistent,however,becauseinany
    giventimeperiodthecentralbankerfacesaconstant

    andthushasanincentivetocreatesurpriseinflation.Itinitiallymightseem
    conceivablethatthecentralbankerwouldpursuetheinflationrateassociated
    withtheidealruleevenwithoutprecommitment.Inparticular,pursuing

    0
    wouldbenefitthecentralbankersreputation,perhapsenoughtocompensatefor
    theshortrunopportunitycost.BarroandGordonsbreakthroughistheir
    incorporationofreputationaleffectsdirectlyintothemodelbyextendingthe
    gametotwoperiods.BarroandGordonshowthatreputationalforcesarenot
    sufficienttoguaranteeadherencetozeroinflation;precommitmentremains
    optimal.
    Inthetwoperiodgame,thecentralbankerhasatemptationtocheatfrom
    theidealpolicyinthefirstperiod,butcheatingresultsinanenforcementpenalty
    inthesecondperiod.BarroandGordonshowthatthecentralbankerwillnot
    pursueazeroinflationpolicybecausethepolicyisnotenforceable.
    4
    Apolicyis
    enforceableundertheBarroandGordondefinitionifthetemptationtocheatis
    lessthantheenforcementpenaltyforcheating.Toshowthatapolicyis
    unenforceable,assumethatitisenforceableandthenderiveacontradictionby
    showingthatthetemptationtocheatoutweighsthepenalty.Ifapolicyis
    enforceable,theninflationexpectationsaresetattheleveldeemedbythepolicy.
    Thusinthiscase,

    0
    4
    BarroandGordonusethetermruletodescribeaninflationpolicy.Thistermisconfusing,
    however,becausethetermimpliesprecommitment.ThepurposeoftheBarroGordonanalysisis
    tosolveforareputationalequilibriumintheabsenceofrules.
    ,sominimizationof

    L
    t
    withrespectto

    yields


    ,thesameresultaspurediscretion.(Thetildeover

    isanotationalconventiontosignifythecentralbankscheating.)Here,thevalue
    ofthelossfunctionis
    (2.3)

    L
    t

    2
    2

    < 0

    L
    t

    2
    2

    < 0
    .
    Temptationisthelosssavedbyabandoningthepolicy,so
    (2.4)

    temptation

    2
    2

    2
    2
    > 0

    temptation

    2
    2

    2
    2
    > 0
    .
    Becausecheatingresultsinanexpectedgain,whilefollowingthepolicy

    0
    resultsinanexpectedlossof0,thereisatemptationtocheat.Theenforcement
    mechanismpostulatesthatcheatingforcesareturntopurediscretioninthe
    subsequentperiod.Theenforcementisthusthepresentdiscountedvalueofthe
    differenceinthenextperiodslossfunctionbetweenthecasesinwhichthepolicy
    isfollowedandabandoned.Here,
    (2.5)

    enforcement


    + 1

    +1
    ( )

    2
    2
    0



    _
    ,

    2
    2
    > 0

    enforcement


    + 1

    +1
    ( )

    2
    2
    0



    _
    ,

    2
    2
    > 0
    ,
    where

    istherateoftimediscount.Since

    q < 1
    ,temptationmustbegreaterthanenforcement.Theidealzeroinflationpolicyis
    thustimeinconsistent,noncredible,andunenforceable.BarroandGordon
    provideaderivationofabestenforceablepolicy,thatisthepolicywhich
    providesthelevelofinflationclosesttotheideal(i.e.,thelowestlevel)giventhat
    thebenefitsfromcreatingasurpriseinflationmustbelessthanthecoststo
    reputation.Suchapolicyprovidesperformanceinferiortothatprovidedbythe
    ideal(ifitcouldbemaintained),buttheyshowthatitisbetterthanpure
    discretion.BarroandGordonsarticlesuccessfullyillustratesthatreputational
    forcescausepolicytoconvergetoacompromisebetweenzeroinflationandthe
    rateassociatedwithpurediscretion.
    BecausetheenforcementmechanisminBarroandGordonsmodelis
    arbitrary,itisdifficulttodeterminewhetheranextensionofthisperfect
    informationgametoaninfinitenumberofperiodsprovidessufficient
    reputationaleffectstoremovetheincentivetocheat.Thisislikelyifcheatinghas
    permanentreputationalconsequencesandfuturelossesarenotheavily
    discounted.Canzoneri(1985),forexample,distrustsBarroandGordons
    conclusionthattheidealsolutioncannotbeachievedwhenthereareno
    informationalasymmetries.TheFed,Canzoneriargues,mightbeableto
    establishcredibilityintheidealpolicysimplybyrunningitforanumberof
    periods.(p.1061)Asensiblecentralbankerwouldrealizethatoutputcannot
    remainpermanentlyabovethenaturallevel,andwouldattempttomaintain
    outputatthenaturallevel.Theremovaloftheperfectinformationassumption,
    however,maymakeinflationdisciplinesufficientlydifficulttoenforcethata
    reputationalenforcementmechanismbecomesineffective.Goodhart(1994)
    providesaclearsummaryofthisposition.Ifthepubliccannoteasilydeduce
    whattheCentralBankistryingtoachieve...expectationswillberevisedless
    quicklywhentheCentralBankdoesshiftitspolicy,Goodhartwrites.Hence,
    theCentralBankcanaffordtobemoreaggressiveinpursuingrealobjectives.
    (p.108)
    Byaddinguncertaintyandimperfectinformationtothegame,Canzoneri
    findsatradeoffbetweenmaintainingcentralbankflexibilitytocombatshocks
    andapplyingrigidrulestolowerinflationexpectations.Canzoneriarguesthatin
    theabsenceofshocks,acountryshouldleaveitscentralbankersnoleeway:
    TheKydlandPrescottgameofprecommitmenthasasimple
    resolutionifthereisnobenefittotheFedsretainingstabilization
    powers:theFedshandsshouldbetied....IftheFedcanplaya
    usefulstabilizationrole,thenanefficientresolutionofthe
    precommitmentproblemrequiresthattheFedshouldretainsome
    flexibility.(p.1062)
    Canzoneridoesnotsupplyamodeltosupporthisfaiththatthecentralbanker
    wouldbewillingtoundertakeacostlydisinflationtobuildupcredibilityinthe
    idealzeroinflationpolicy.Inanyevent,however,amodelthatsuggeststhe
    inevitabilityofachievementoftheidealpolicywouldneedtobediscardedon
    empiricalgrounds;thepersistenceofhighlevelsofinflationinmanycountries
    suggestthatcentralbankersareindeedoftenunabletoachievethissolution.
    Canzonerisinnovationishisdemonstrationthatinformationalasymmetries
    associatedwithshockscanfrustrateattemptstoobtainacooperativesolution.
    Canzoneriintegratesshocksintohismodelbysuggestingthatacentral
    bankmaynotbeabletotargetinflationperfectly.Specifically,heassumesthat
    (2.6)

    g
    t

    g
    t

    ,
    where

    g
    t
    isthecentralbankstargetedgrowthrateofthemoneysupply,and

    isastochasticdisturbancetomoneydemand.Thecentralbankislikelytohavea
    predictionof

    beforesettingatargetinflationrateforperiod

    .However,thecentralbanks
    predictionof

    maybeprivateinformation,makingitdifficultforthepublictodifferentiate
    cheatingfrominaccurateestimatesof

    .Specifically,Canzoneridecomposesthedisturbancetomoneydemandas
    follows:
    (2.7)

    ,
    where

    e
    t

    isthecentralbanksforecastof

    ,and

    istheforecasterror.Forexample,thecentralbankmightbaseitsforecast

    e
    t

    onpastvaluesof

    ,and

    canbeinterpretedasafundamentalshocktomoneydemandinperiod

    thatthe
    centralbankcouldnotanticipate.Attheendofperiod

    ,theprivatesectorknows
    thevalueof

    ,butcannotseparateitintoitscomponents.Thecentralbankthusmaybeableto
    engineerasurpriseinflationwithoutlosingcredibility.Forexample,supposethe
    centralbanks

    e
    t

    isnegative,requiringcompensationwithdecreasedmoneygrowthtomaintain
    lowinflation.Thecentralbankmightnotcutbackonmoneygrowthasmuchas
    isneededtoachievethelevelofinflationconsistentwiththenaturallevelof
    output.Themoneysupplygrowththatresultswouldbeappropriatefor
    targetingthenaturallevelifthevalueof

    e
    t

    werelessnegative.
    Thepublicneverfindsout

    e
    t
    ,andmaybelievethatthecentralbankisindeedtargetingthenaturallevel.If
    (unbeknownsttothepublic)

    0
    ,thecentralbanksdecisionwilllikelygoundetected.Thedisturbancethatthe
    privatesectorobserves,

    ,wouldbeconsistentwithaslightlynegative

    e
    t
    andaslightlynegative

    .Inotherwords,thecentralbankhopesforapositivevalueof

    tocompensateforactionsconsistentwithadeliberateunderestimate(inabsolute
    terms)of

    e
    t
    .Ofcourse,if

    islargeandnegative,thepublicwillsuspectthecentralbanksdeceptionand
    credibilitywillbelost.Canzonerinotesthatinthelongrun,thepublicwillbe
    abletoguessthatthecentralbankisattemptingtopushoutputabovethenatural
    level.However,theasymmetryinherentinprivateinformationmakesthegame
    sufficientlycomplicatedthatacooperativeequilibriumwillbehardertoachieve.
    Thereisthusatradeoffbetweenstabilizationandinflation.Acentralbankwith
    theflexibilitytocombatshocksisalsolikelytocheatandattempttoachievepart
    ofitsoutputgoal.Arulecanpreventsuchtrickeryonlybyenjoiningthecentral
    bankfromfightingshocks.AstrengthofCanzonerismodelisthatitisconsistent
    withempiricallyobservedperiodicboutsofinflationassociatedwithdiminished
    credibility.Suchboutswouldoccurwhen

    islargeandnegative.Alimitationofthemodelisthatflexibilityisanallor
    nothingproposition.Institutionalprecommitmentpreventsthecentralbank
    fromrespondingeventothelargestshocks.
    FloodandIsard(1989)constructamodelthat,likeCanzoneris,supposes
    thattheprobabilitythatacentralbankeriscaughtdependsonthemagnitudeof
    afundamentalshock,whichthebankercannotpredict.IntheFloodIsardmodel,
    however,boutsofinflationcomeonlywhenthecentralbankeractstocounteract
    aparticularlylargepredictedshock.Specifically,FloodandIsardpostulatea
    mixedstrategyonthepartofthecentralbanker.Thecentralbankermakesno
    attempttocountersmallshocks,actingonlyinresponsetolargeones.Thisis
    intuitivelyreasonable;evenarelativelyinflationaversecentralbankerislikelyto
    consenttosomemoneygrowthafteralargenegativedemandshock.For
    example,thecentralbankermightfollowanidealmoneygrowthpolicy,

    g
    t
    0
    ,wheneveritspredictionof

    ,i.e.

    e
    t
    ,islowinabsoluteterms.Thecentralbankerthusinthesecasesreapsthe
    benefitsofarule,acrediblecommitmenttolowinflation.However,whenthe
    banksshockforecastexceedsacertainthreshold,i.e.

    e
    t
    >
    ,thecentralbankerdecidesthatitcannotaffordtoignoretheshock.One
    responsenotquitetheoneFloodandIsardpostulatewouldbeforthebankto
    set

    g
    t

    ,andasaconsequence

    ( )

    .Ifabankweretorespondsymmetricallytosuchshocks,andtherewererational
    expectationsandnoprivateinformation,thenexpectedinflationwouldbezero
    regardlessofthethreshold.Givenprivateinformation,however,whenthereisa
    largeandnegative

    ,inflationwillbehighandpositive,andthepublicmayincorrectlybelievethat
    thecentralbankhasresortedtomoneygrowthwhentherewasasmallshock.
    Thecentralbankthussuffersacredibilitycrisis,andinflationexpectationsrise.
    Thoughprivateinformationthusisnecessarytopredictperiodicboutsof
    inflation,inflationexpectationscanbepositiveintheFloodIsardframework
    evenifallinformationispublic.Themodelspecifiesthatwhentheshockforecast
    exceedsathreshold,thebankresortstodiscretion.Thus,givenan

    e
    t
    >
    ,thecentralbankerwouldinfactsetmoneygrowth

    g
    t
    >

    .Theexpectedrateofinflationthusbecomesaweightedaverageoftheexpected
    inflationratewithpurediscretionandtheexpectedinflationratewithabinding
    commitmenttotheidealrule.Theweightonthediscretionarycomponentofthe
    averageistheprobabilitythatashockwillexceedtheminimumthresholdinany
    givenperiod.
    TheBarroGordon,Canzoneri,andFloodIsardmodelsallimplythat
    completeorpartialprecommitmenttolowinflationmaybewelfareimproving.
    Ifaninstitutionalrestraintisbinding,therestrainteffectivelysetsbothactualand
    expectedinflationtothesamevalue.Forexample,aninstitutionalrestraintcould
    bindcentralbankerstoamonetarypolicyformulathattakesintoaccountvarious
    indicatorsofthestateofthemacroeconomy.Severalauthorssuggestthat
    developmentofsucharulemightbepossible,butitisimpossibletoknow
    whetherfinancialinnovation,technologicalprogressandothereconomic
    developmentsmightsomedaymaketheeconomysodifferentfromtodaysthat
    therulewouldcodifyapoorpolicyprescription.Indevelopmentofaframework
    thatallowsforbindingcommitmentofmonetarypolicymakers,thereisa
    tradeoffbetweenreputationandflexibility.Arigidrulepassedbyaparliament
    mightbequitereputable,assumingthepublicbelievesthechanceofa
    parliamentaryreversalunlikely.However,itmightalsorestraincentralbankers
    abilitiestorespondtouniqueorunforeseencircumstances,suchasshocksor
    moredrasticchangesineconomicstructure.AsNeumann(1991)argues,Fixed
    moneyrulescannotcopewithchangesinthetrendsofrealgrowthorvelocity.
    (p.96)
    Itispossibletodeviseinstitutionalrestraintsoninflationapartfromrigid
    moneygrowthrules.GiavazziandPagano(1992)developamodelwhich
    incorporatesbenefitsaccruedfromaninstitutionalframeworkthatminimizes
    policymakersdiscretion.Inparticular,theyarguethatacentralbankwithapoor
    reputation(i.e.,apasthistoryofinflationsurprises)canimproveitsreputation
    bycrediblypeggingthecountryscurrencytothatofacountrywithconservative
    monetaryauthorities.Suchacrediblecommitmentcouldcome,forexample,
    fromacountrysdecisiontocedemonetarysovereigntytoalargermonetary
    union.Theindividualcentralbankmayhavehighincentivestocreatesurprise
    inflations,makingitdifficulttopursueoptimalpolicies.Earningreputationvia
    pursuitofexpensivenoncrediblepoliciesrequirestime,butinstitutional
    transformationcanbringimmediatereputationalrewards.Aninstitutional
    commitmentisthusaneasywayoutofasuboptimalrationalexpectations
    equilibrium.Ifthelargermonetaryunionincorporatesthepreferencesofa
    numberofcountries(forexample,byincludingasgovernorsonitsboard
    representativesfromvariouscountries),theincentiveforinflationsurprises
    couldbelower.Thiswouldlikelybethecaseiftheothercountriescentral
    bankerswererelativelyconservative,forexampleifItalyweretosurrender
    authorityoveritsmonetarypolicytotheGermanBundesbank.Giavazziand
    Paganoarguethatthecountryspolicymakersbenefitbytyingtheirhands,i.e.
    leavingmonetarypolicytoaninstitutionoverwhichtheyhavenocontrol.In
    practice,thecostsofsuchaconcessionmayexceedthebenefits.AgoalofItalys
    monetarypolicyistooffsetdisturbancesintheItalianeconomy.IfItalywereto
    cedemonetarysovereigntytoGermany,Italianidiosyncraticdisturbancesmight
    notbeadequatelyaddressed.Thisproblemisapersistentthemeoftheoptimal
    currencyarealiterature,particularlyMundell(1962).Alessdrasticmeansof
    tyingmonetarypolicymakershandsmaythusbedesirable.
    Rogoff(1985)suggestsadifferentwayofachievingreputationalbenefits.
    Hearguesthatitmightmakesenseforvoterstotietheirownhandsbyelectinga
    centralbankerwhoismoreinflationintolerantthanthemedianvoter.Adopting
    relativelynonrestrictiveassumptions,Rogoffprovesthatitmakessensefor
    voterstoelectacentralbankerwhoplacesmorebutnotinfiniteemphasison
    fightinginflationthantheydo.Specifically,supposethatthesociallossfunction
    correspondingtothepreferencesofthemedianvoterlookslikethis:
    (2.8)

    L
    t

    ( )

    L
    t

    ( )
    .
    where

    a b
    representstheemphasisthemedianvoterplacesonfightinginflationrelativeto
    unemployment.Supposethatvoterscanselectacentralbankerwithadifferent
    sociallossfunction,suchthat
    (2.9)

    L
    t
    + ( )

    ( )

    L
    t
    + ( )

    ( )
    ,
    where


    isaparameterofthecentralbanker.Rogoffprovesthatthesociallossof
    Equation2.9isminimizedbyelectingacentralbankerwithapositivethoughnot
    infinite


    .Electionofsuchacentralbanker,occasionallyreferredtointheliteratureasa
    perversepolicymaker,providesimmediatebenefitsbyloweringinflation
    expectations.Atanygiventime,thevoterwhoselectsthecentralbankerwill
    preferthatthebankeradoptalessrestrictivemonetarypolicy,butthebankers
    conservativebiasmakesalowinflationrationalexpectationsequilibrium
    possible.Fromthevotersperspective,theidealcentralbankerwouldbeone
    whosepresumedconservativebiaswouldlowerinflationexpectations,butwho
    wouldinfactadoptthevotersoutputinflationtradeoff.Ofcourse,sucha
    centralbankerisimpossibletofind,becauseallvotersareassumedtohave
    rationalexpectations,andexpectationswouldadjusttoreflectthecentral
    bankerspolicies.Electionofaconservativecentralbankermakespossiblethe
    implementationofatimeinconsistentlowinflationpolicy.Totheextentthat
    independentcentralbankstendtohaveconservativecentralbankers,central
    bankindependenceisaninstitutionalconstraintthatallowsvoterstobenefitby
    tyingtheirownhands.
    AsintheanalysesofCanzoneriandIsardandFlood,Rogoffsargument
    impliesthatthereisatradeoffbetweencentralbankflexibilityandlowinflation.
    Onefactordeterminingtheoptimalvalueoftheparameter


    isthevarianceofproductivitydisturbancesintheeconomy.InRogoffsmodel,
    aggregatesupplyinperiod

    dependsontheeconomysfixedcapitalstock,
    quantityoflabor,andanaggregateproductivitydisturbanceinthatperiod,

    z
    t
    .Becauseproductivitydisturbancesaredeviationsfromlongruntrends,the
    expectedvalueofthiscomponentofaggregatesupplyis0.However,the
    expectedvalueof

    z
    t
    2

    maybehigh,implyinggreatvolatilityofdisturbances.Assumingthat

    z
    t

    isameanzerovariable,thisexpectedvalueis

    2
    .Rogoffaddstothesociallossfunctionathirdtermwhichmeasureshow
    successfullythecentralbankoffsetsdisturbancestostabilizeemploymentand
    inflation.(p.1176)Heshowsthistermtobepositivelycorrelatedwith

    2
    ,suggestingthatahighvarianceimpliesagreatersocialloss.Rogoffdoesnot
    specificallyindicatewhethertheoptimalvalueof


    ispositivelyornegativelycorrelatedwith

    z
    2
    .Intuition,however,suggeststhat
    thereshouldbeanegativecorrelation.Thehigher

    a
    ,themorerigidthecentral
    bankerwillbeinpursuitofaninflationtarget.Acostofthisrigidityisalackof
    flexibilityincombatingproductivityshocks.Thenextchaptermakesasimilar
    tradeoffexplicitevenwithouttheinclusionofastabilizationterminthesocial
    lossfunction.
    Chapter3:EndogenizingCentralBank
    Independence
    Whoknowswhensomeslightshock...shallsendtheskyscrapersinourcitiestoppling?
    RichardWright
    Thischapterdevelopsasimplemacroeconomicmodelofacountrys
    decisionwhethertoadoptanindependentcentralbank.Theframeworkisa
    stochastic,rationalexpectationswagecontractingmodel,inwhichwagesetters
    incorporateinflationexpectationsintocontractsatthebeginningofeachperiod.
    Theassumptionofthismodelisthatacountrywillchoosetoadoptan
    independentcentralbankiftheexpectedvalueofthesociallossfunction
    associatedwithfollowingaruleislessthanthatassociatedwithpursuitof
    discretion.Arulelowersinflationexpectations,abenefit.However,solepursuit
    ofinflationtargetsmakesthecentralbankinflexibleinrespondingtodemand
    shocks,acost.Acountryisassumedtoadoptanindependentcentralbankwhen
    thebenefitofindependenceexceedsthecost,acomparisonwhichthesocialloss
    functionmakesprecise.Later,thisassumptionwillbemodifiedtoallowfora
    continuouscentralbankindependencevariable.
    Fornow,assumecentralbankindependenceequivalenttoanirreversible
    andthuscrediblecommitmenttoazeroinflationrule.Centralbankdependence
    isassumedequivalenttopursuingdiscretion.Theseassumptionsrestsonthe
    intuitivelyappealingnotionthatindependentcentralbanksarelikelytohave
    conservativecentralbankerswhoplaceapremiumonadherencetolowinflation
    targets.Thedichotomyisasimplification,ascentralbankindependencedoesnot
    necessarilyrequirecompletelygivingupdiscretion.Inasense,dependencemay
    interferewithacentralbanksdiscretionbyrequiringacentralbankto
    accommodatefiscalpolicy.Suchanaccommodation,however,istheresultofthe
    fiscalauthoritiesenforcingtheirdiscretionaryurgesonapotentiallyresistant
    centralbank.Likewise,whileanindependentcentralbankisfreetouse
    discretion,itisassumedtobelesslikelytoexploitthisfreedom.
    Thesociallossfunctionminimizedbythecentralbankisnotthesameloss
    functionthatwagesettersusetosettheirinflationexpectations.Thelossfunction
    forwagesetterscanbedefinedasfollows:
    (3.1)

    LW
    t
    (

    )
    2
    .
    Wagesettersgoalissimplytoforecastinflationasreliablyaspossible.
    Effectively,wagesetterswouldliketobeabletosetrealwages,butlabormarket
    distortionsmakeittoocostlytofullyindexwagecontracts.Wheninflation
    expectationsareaccurate,thewagesetterslossfunctioniszerobecausethe
    anticipatedrealwageisequivalenttotheactualrealwagecorrespondingtothe
    nominalwagesetincontracts.Wheninflationislowerorhigherthan
    expectations,therealwagewassetataninappropriatelevel.Whilehighinflation
    wouldpresumablythusbenefitfirmsattheexpenseofworkers,andlow
    inflationwouldhavethereverseeffect,wagesettersforsimplificationare
    presumedtoactcooperativelyinsettinginflationexpectations.Itisperhapsbest
    tothinkofthewagesetterslossfunctionasreflectingnottheirgoals,butrather
    theirbehaviorofsettinginflationexpectationsrationally.Wagesettersasvoters
    mayhopethatsocietyachieveslowlevelsofinflation.However,becauseno
    singleeconomicagenthasasignificanteffectonaggregateinflation,individuals
    donothaveanincentivetocontributetosuchagoalbyloweringtheir
    expectations.Thewagesetterslossfunctionthusreflectsonlyinaccurate
    expectationsofinflation,eventhoughhighlevelsofinflationmayhurtorhelp
    wagesetters.
    Thegoalsofthecentralbankaretominimizetheabsolutelevelofinflation
    andtokeepinflationascloseaspossibletothelevelcorrespondingwiththe
    sociallyoptimallevelofoutput,whichmayexceedthenaturallevel.In
    particular,definethesociallossas
    (3.2)

    LS
    t

    2
    + (


    )
    2
    .
    Thefirstterminthelossfunctionisaninflationobjective,whilethesecondisan
    outputobjectiveexpressedintermsofinflation.Theconstant

    representsthe
    relativeimportancesocietyplacesonachievinglevelsofoutputclosetothesocial
    optimum.Ifsocietyisrelativelyindifferentbetweenachievingitsoptimallevelof
    outputandthenaturallevel,then

    iscloseto0.Also,themoreimportantthe
    inflationgoalisrelativetotheoutputgoal,thelowertheconstant

    .Theconstant
    isthusanormalizationoftheconstants

    and

    inBarroandGordons(1983)
    model.
    ThesecondtermofthelossfunctionmodifiesthatoftheBarroGordon
    model.
    5
    IntheBarroGordonmodel,thistermmeasuresthebenefitsofasurprise
    inflation,withmoreinflationyieldinggreaterbenefit.Thesecondtermofthis
    lossfunction,incontrast,capturesthecostofnotmeetingtheoutputgoal,with
    deviationsfromthegoalineitherdirectioncarryinganincreasingcost.This
    improvementisachievedviathequadraticspecificationoftheterm,in
    conjunctionwiththeintroductionoftheconstant


    .Thisconstantrepresentsthedifferencebetweeninflationandexpectedinflation
    whenthecentralbankerensuresthatoutputissetattheoptimallevel,i.e.,the
    surpriseinflationthecentralbankermustaccepttoachievethesociallyoptimal
    levelofoutput.Thus,

    and

    f (


    )
    2
    0
    when

    ,where

    isoutputand


    itssociallyoptimallevel,greaterthanthenaturallevelof

    Y
    n
    .Ifthesociallyoptimalandnaturallevelsofoutputareequal,then
    5
    Thechangeinspecificationofthelossfunctionisnontrivial.Yeung(1991)showsthatevenina
    verygeneralversionoftheBarroGordonframeworkthatdoesnotdependonthequadratic
    linearstructureofEquation2.2,thereisapositiveinflationbias.However,BarroandGordons
    proofthatthetemptationtobreaktheidealpolicyisgreaterthantheenforcementfordoingso
    neednolongerhold.Itcanbeshownthatwiththissetuptheresultwillnotholdiftherateof
    timediscountisgreaterthan2/(2+2f).

    0
    .Figure3.1illustratestherelationshipamongthesevariables.
    Figure 3.1: Surprise Inflation and the Central Banks Output
    Goal
    Given an expectationsaugmented (shortrun) Phillips curve related to output by
    Okuns law, a central banker can achieve output equal to the socially optimal level
    only by setting inflation a sufficient amount above expectations. The difference
    between this required inflation and expected inflation is constant regardless of the
    level of expected inflation, as long as all expectations-augmented Phillips curves
    share the same slope at the socially optimal level of output.

    e
    Y

    PC

    t
    t

    Y
    n
    Y
    *
    Withadependentcentralbank,thecentralbankchoosesateachperiod
    thelevelofinflationthatminimizesthesociallossfunction.Becauseexpectations
    arealreadyset,minimizationmustbewithrespectto

    ,taking

    asconstant.So,
    (3.3)

    + 2(


    ) 0

    + 2(


    ) 0
    .
    Atrationalexpectationsequilibrium,however,

    .Thus,when

    0
    ,
    (3.4)




    .
    6
    Since

    2
    2 +1
    ( )
    > 0
    ,thesecondorderconditionforminimizationofthelossfunctionholds.Asthe
    BarroGordonmodelpredicts,thereisapositiveinflationbias.Animportantand
    intuitiveconsequenceofEquation3.4is
    6
    Henceforth,tildesovervariablesorfunctionsareusedtorepresentvaluesassociatedwith
    discretionandcentralbankdependence;incontrast,barsrepresentvaluesassociatedwithrules
    andcentralbankindependence.
    (3.5)


    > 0


    > 0
    ,
    soamongcountrieswithdependentcentralbanks,expectedinflationishigh
    whereoutputgoalsarerelativelyimportant.
    Thecostofcentralbankindependenceisthelimitedflexibilityimposedby
    arule.Inparticular,assumethatarulepreventsmonetarypolicyresponsesto
    demandshocks.Anegativedemandshock,forexample,wouldcauseoutputto
    fallbelowthenaturallevel.Intheshortrun,inflationfalls,astheeconomy
    movesalongthePhillipscurve.Inflationexpectationsadjusttotheshock,but
    withalag.Supposethatasaresultofapositivedemandshock,outputgrowthin
    period

    changesfrom

    y
    n

    to

    y
    t
    .Let

    z
    t
    representthedifferencebetweentheactualandnaturalratesofoutputgrowth,
    definedby

    z
    t

    .Thevariable

    z
    t
    thusrepresentstheoutputconsequencesofademandshockinperiod

    .The
    shocktoinflationcorrespondingtothisdemandshockcanbedirectlycomputed.
    SupposethemodifiedPhillipscurverelatinginflationandoutputisastraight
    linewithslope

    m
    .Then,

    .Let

    representthedeviationofinflationfromtheratecorrespondingtothenatural
    levelofoutput,definedby

    .Thus,
    (3.6)

    .
    Thedefinitionsof

    z
    t
    and

    specifythattheyarethedeviationofoutputandinflationfromtrendaftera
    countryhasattemptedstabilizationofademandshock.Thesedeviationsare
    smallerthanthosethatwouldresultintheabsenceofautomaticandother
    stabilizers.Theremainderofthischapterfocusesontheinflationratherthanthe
    outputconsequencesofshocksbecauseEquation3.2isexpressedintermsof
    inflation.Equation3.6,however,impliesthattheresultsconcerninginflation
    applyalsotooutput.Thus,thoughthemotivationofthispaperisananalysisof
    outputstabilization,itisconvenienttodevelopthetheoreticalmodelintermsof
    inflation.
    Acentralbankerwhohasdiscretiontosetinflationafterinflation
    expectationsareestablishedmaybeabletocompensatepartlyforaninitialshock
    andreturnoutputtowardthenaturallevel.Beforedefiningthebenefitsofthis
    discretion,itisusefultoexaminetheinitialinflationshockthatacentralbanker
    facesandconvertsintotheeffectiveinflationshock

    .Specifically,supposethatinperiod

    ,aneconomyissubjecttoaninitialinflation
    shock

    e
    t
    ,where

    e ~ N(0,

    2
    )
    .Further,supposethatincountriesbothwithandwithoutindependentcentral
    banks,thepreviousperiodsshocklingers:
    (3.7)

    e
    t

    1
    +

    e
    t

    1
    +

    ,
    where

    isanewfundamentalshockinperiod

    t

    and


    isaconstantwith

    0 < < 1
    .Thepreviousperiodsshockandthefundamental
    shockareassumedtobeindependentrandomvariables.Forexpositionalclarity,
    thispaperassumesthatstabilizationpolicymaybetosomeextentableto
    counteracttheeffectsof

    e
    t1

    tominimizetheeffectiveshockinperiod

    ,butitisunabletocounteractthe
    fundamentalshock;i.e.,thereisnoconcurrentstabilization.Theconstant


    representstheabilityofeconomiestostabilizepastshocksintheabsenceof
    centralbankaction.Forexample,countrieswithrelativelyflexiblewagesand
    priceswillhavelow


    values.Becausethispaperisconcernedwiththepotentialofcentralbanksto
    providestabilization,itdoesnotconsiderthesourcesofvariabilityin

    .Theconstant


    isthusassumedtobethesameacrosscountries.Because


    doesnottakeintoaccounttheadditionalstabilizationpowerthatdependent
    centralbanksmayprovide,defineanadditionalconstant,

    ,where
    (3.8)


    1
    +


    1
    +

    ,
    and

    representstheeffectiveinflationshockwithdiscretion.Incountrieswith
    dependentcentralbanks,

    thusrepresentsthedeviationinperiod

    fromthelevelofinflationcorresponding
    tothenaturallevelofoutput.Incountrieswithindependentcentralbanks,

    .Independentcentralbanksarethusassumedtoprovidenostabilizationbenefits
    beyondthoseaffordedbyautomaticstabilizers.
    Incountrieswithdependentcentralbanks,theconstantproduct

    isthusanindicatoroftheoveralleffectivenessofstabilization.If

    0
    ,stabilizationisperfect;thecountryisabletocompletelycounteracttheeffectof
    pastshocks.If

    1
    ,stabilizationisneutral;thecountryisunabletomitigatepastshocksatall.These
    extremesprovideusefulbenchmarks,butarethemselvesimpossible.The
    imperfectionsofmonetarypolicyguarantee

    > 0
    ,whilelongrunselfcorrectivemechanismsensure

    < 1
    .Itispossible,however,thatattemptsatneutralizingshockshavedestabilizing
    effects.Ifdependentcentralbanksdestabilize,then

    > 1
    .Thisisconsistentwiththeoriessuggestingthatthegovernmentisthesourceof
    disturbances,ratherthanthecureforthem.Becausethismodelproposesno
    additionalbenefitsofcentralbankdependence,if

    1
    ,thentheonlyrationaldecisionisadoptionofanindependentcentralbank.In
    thisscenario,thereisnotradeoffbetweenstabilizationandlowerinflationary
    expectations.Thustodevelopthemodel,thispaperassumesfornowthat

    0 < 1
    .
    Toclarifythedefinitionsofperfectandneutralstabilizationpolicies,
    considertwohypotheticaleconomies,CountryAandCountryB.Suppose
    CountryAachievesperfectstabilization,whileCountryBsuffersfromneutral
    stabilization.Figure3.2illustratesthecaseinwhichapositivedemandshockhits
    bothcountriesinperiod1.Withperfectstabilization,outputreturnstothelong
    runequilibriumlevelinthenextperiod.Withneutralstabilizationandthesame
    positiveshocktodemand,outputinperiod2isthesameasinperiod1.Inboth
    cases,anadditionalshocktodemandorsupplycouldcausefurtherdeviationof
    outputfromtheequilibriumvalue.Forsimplicity,however,Figure3.2assumes
    thatthereisnoadditionalshockinperiod2,i.e.,

    2
    0
    .BecauseCountryArunsaperfectstabilizationpolicy,outputdeviatesfrom
    longrunaggregatesupplyforonlyoneperiod,whileinCountryBitdeviatesfor
    twoperiods.
    Figure 3.2: Perfect vs. Neutral Stabilization
    Country A and Country B experience the same positive demand shock, moving
    aggregate demand from AD
    0
    to AD
    1
    . Because Country A enjoys perfect stabilization,
    assuming there are no further shocks, aggregate demand returns to its original level
    in the next period. In Country B, which suffers from neutral stabilization, the
    aggregate demand shock is not at all offset, and aggregate demand will not return
    to its original level until it is offset by another shock.
    AD
    22
    YPLRAS AS AD = AD
    10
    Y ,
    Y
    01
    Y Country A
    (Perfect Stabilization)
    2
    YPLRAS AS AD AD = AD
    10
    Y
    021
    Y ,
    Y
    Country B
    (Neutral Stabilization)
    Because

    e
    t1
    and

    areindependentrandomvariables,inacountrywithadependentcentralbank,
    Equation3.8implies
    (3.9)

    2
    +

    2

    2

    2
    +

    2
    +

    2

    2

    2
    +

    2
    .
    Thevarianceoftheinitialandfundamentalshockscanbedirectlyrelatedby

    .Specifically,

    2

    2

    2
    +

    2
    ,so

    2
    1 1
    2
    ( )

    2
    .Thus,
    (3.10)

    2
    1
    2
    +1



    _
    ,

    incountrieswithdependentcentralbanks.Similarly,
    (3.11)

    2
    1
    2
    + 1



    _
    ,

    1
    1
    2



    _
    ,

    2
    incountrieswithindependentcentralbanks.Now,let

    c
    2

    2
    1
    2
    ( )
    [ ]
    +1
    ,and

    c 1 1
    2
    ( )
    .Thus,

    2
    and

    2
    .Forboth

    and

    c
    ,lowervaluesimplybetterstabilization.Since

    2
    < 1
    ,

    c >


    ,sodiscretionlowersthevarianceofthedeviationofinflationfromtrend.
    Assumethatcurrentshocksdonotaffectinflationexpectations.This
    assumptionisrealisticifwagesetterscommittocontractscoveringasufficient
    amountoftimethatcurrentshockshaveanegligibleeffectonaveragefuture
    inflationlevels.Itfollowsthat

    .Thisconclusionallowsevaluationoftheexpectedvalueofthewagesettersloss
    functionandthesociallossfunctioninboththecaseofanindependentcentral
    bankandinthecaseofadependentone.Thewagesetterslossfunction
    evaluatesto:
    (3.12)

    ELW
    t

    ( )
    2
    [ ]

    2
    [ ]

    2
    ,
    where

    denotestheexpectationfunction.Thewagesettersexpectedlossisthus
    equivalenttothevarianceoftheshocks;onlyunanticipatedeconomicevents
    causeactualinflationtodifferfromexpectedinflation.Thisisconsistentwitha
    rationalexpectationsmodel,sinceinflationexpectationsareassumedto
    incorporateallstructuralinformationabouttheeconomy,butnotthesizeof
    shocksinindividualperiods.Note,however,thatdiscretionlowersthevariance
    ofeffectiveshocks,i.e.,

    2
    >

    2
    .Thus,theexpectedlossofwagesettersisgreaterwithanindependentcentral
    bank:

    ELW
    t
    >

    .
    Ifacountrycommitstoanindependentcentralbankthatfollowstheideal
    rule,then

    0
    ,so

    0 +

    .Theinflationrateisnotsubjecttoaninflationbias,butisaffectedbyshocks.
    Theexpectedvalueofthesociallossfunctionisgivenby
    (3.13)

    ELS
    t

    2
    +



    ( )
    2
    [ ]

    2
    +


    ( )
    2
    [ ]
    .
    Because

    2
    ,thisevaluatesto
    (3.14)

    ELS
    t
    + 1
    ( )

    2
    +


    2
    +1
    ( )

    2
    +


    2
    .
    Incontrast,adependentcentralbankconductsdiscretionarystabilizationpolicy
    ratherthanadheringtoarule.Theinflationratehasapositivebias,butisstill
    affectedbyshocks.FromEquation3.4,
    (3.15)

    .
    Theexpectedvalueofthesociallossfunctionisgivenby
    (3.16)

    E LS
    t

    2
    +



    ( )
    2
    [ ]

    ( )
    2
    +


    ( )
    2
    [ ]
    .
    Because

    2
    ,a
    consequenceisthat
    (3.17)

    E LS
    t
    +1
    ( )

    2
    + + 1
    ( )


    2
    + 1
    ( )

    2
    + + 1
    ( )


    2
    .
    Acountrywillchoosecentralbankindependence(i.e.,therule)when

    ELS
    t
    <

    ,or
    (3.18)

    f +1
    ( )

    2
    +


    2
    < + 1
    ( )

    2
    + + 1
    ( )


    2
    .
    TheleftsideofInequality3.18representstheexpectedvalueofthesocialloss
    functionwhenaruleisfollowed,andtherightsiderepresentstheexpectedloss
    underdiscretion.Thefirsttermonbothsidesdemonstratesthatahigher
    incidenceofshocksworsenstheexpectedsocialloss.Because

    c >


    ,thislossisgreaterwithanindependentcentralbank.Thesecondtermonboth
    sidesoftheinequalitysuggeststhatthegreaterthedivergencebetweenthe
    sociallyoptimalandnaturallevelsofoutput,themoreseveretheexpectedloss.
    Because

    f


    representsapositiveinflationbias,

    f +1 > 1
    ,sothispenaltyisgreaterinthecaseofdiscretion.Inequality3.18thuscaptures
    theintuitivetradeoffbetweenaruleanddiscretion.Witharule,greatervariance
    ofshocksresultsingreaterlossduetouncertainty,butthismaybebalancedby
    thelowerinflationexpectationsthatarulebrings.Algebraicmanipulation
    transformsInequality3.18to
    (3.19)

    2
    <

    2


    2
    + 1
    ( )



    ( )

    .
    Theexpression


    representstheminimumvalueof

    foracountrytochoosediscretionratherthanarule.Asexpected,countrieswith
    greaterlevelsofshocksaremorelikelytooptfordiscretionintheformofa
    dependentcentralbank.Notethatif

    c

    < 0
    ,i.e.ifstabilizationisbetterwithanindependentcentralbank,thedirectionof
    Inequality3.19isreversed,and,sincetherightsideoftheinequalityisthen
    negative,everycountryscentralbankshouldbeindependent,regardlessofthe
    sizeofshocksorpreferences.
    Severalimportantconsequencesemergefromdeterminingwhateffect
    changesinthe

    f
    ,


    and

    constantshaveonthevalueof

    .First,
    (3.20)

    + 2
    ( )


    2
    + 1
    ( )
    2



    ( )
    > 0
    ,and
    (3.21)

    2
    2


    + 1
    ( )



    ( )
    > 0
    .
    Soacountryinwhichitisrelativelyimportanttoachievethesociallyoptimal
    levelofoutputorinwhichtheoptimallevelisrelativelyfarfromthenatural
    levelismorelikelytochoosetohaveanindependentcentralbank.Sucha
    country,ineffect,hasthemosttogainfromaperverse,inflationintolerant
    centralbanker.Thisresultmightseemcounterintuitive,asacentralbankusing
    discretionhasmoreincentiveforanygivenrateofexpectedinflationtoinitiatea
    surpriseinflationthatwouldallowoutputtoapproachtheoptimallevel.
    However,becausethismodelassumesrationalexpectations,therelativelylarge
    temptationtocheatleadstocostlyhighinflationexpectationsinadiscretionary
    regime.Theconsequenceisthatoutputisnomorelikelytobeatthesocially
    optimallevelinadiscretionaryregimethaninacountrywithanindependent
    centralbank.Lastly,
    (3.22)




    ( )

    2


    2
    + 1
    ( )



    ( )
    2
    < 0
    .
    Sothegreatertherelativeeffectivenessofstabilizationwithdiscretion,thelower
    thelevelofshocksneedbetocauseacountrytooptfordiscretionratherthana
    rule.Inacountrythatcouldcreateacentralbankabletoeffectivelycombat
    shocks,thereisanincentivetousethisabilitybycreatingadependentcentral
    bankthatusesdiscretionratherthanarule.
    Alimitationofthemodeldevelopedsofarinthischapteristhatit
    assumesthatacountrychooseseithertoadoptacompletelydependentora
    completelyindependentcentralbank,withnograyareainbetween.This
    assumptionisatoddswithindicesofcentralbankindependencedescribedin
    Chapter4,whichreflectaspectrumofindependenceoptions.Also,Inequality
    3.19istroublingbecauseitsuggeststhatacountrywillnecessarilychoosecentral
    bankindependenceif

    2
    <
    .Amorerealisticconclusionwouldbethatacountryismorelikelytochoose
    centralbankindependencethelower

    isrelativeto

    ,butavarietyofpoliticalandotherfactorsmayinfluencethedecision.
    Developmentofamodelthatsupportsthecontinuityoftheindependence
    variablewouldnotresolvethisproblem.However,suchamodelwouldposita
    locationforagivencountrysbankontheindependencecontinuum,with
    implicitrecognitionthatfactorsbeyondtheconstantsdetermining


    maycauseacountrytohavesomewhatmoreorsomewhatlessindependence.
    Suchaconstructionisricherthanonewhichconcludesthatacountry,because

    isslightlylessthan

    ,islikelytohaveacompletelyindependentbankbutmayinfacthavea
    dependentone.
    Theremainderofthischapterextendsthemodeltoallowforacontinuous
    centralbankindependencevariable.ThemodelofFloodandIsard(1989),
    summarizedinChapter2,providesaframeworkwithinwhichtoaccomplish
    this.Centralbankindependencesimplyincreasestheprobabilityinanygiven
    periodthatacentralbankerfollowsazeroinflationpolicy.Determinationofthe
    optimaldegreeofindependencerequiresminimizingaprobabilityweighted
    averageoftheruleanddiscretionlossfunctionswithrespecttotheweights.A
    countrydeterminingwhatdegreeofcentralbankindependencetoselectthus
    minimizesthefollowingexpectedlosswithrespectto

    :
    (3.23)

    ( )
    ( )
    + 1
    ( )

    ( ) >
    ( )
    ,
    wheretheprimein

    denotesthatamixedstrategyisusedincomputingtheexpectedlossinperiod

    .
    The

    parameteristheprobabilitythatthecentralbankoptsfortherulerather
    thandiscretioninagivenperiod.Acountryisthusassumedtoset

    toahigh
    valuebyguaranteeingsubstantialindependence,andtoalowvalueby
    maintainingdependence;thisvariablecanthusbetakenasadirectproxyfor
    independence.The


    parameteristhethresholdbeyondwhichacentralbankresortstodiscretionary
    policy.Theexpectedvaluesofthelossfunctionsaredefinedconditionaltothe
    expectationthatashockwillbelowerorhigherthan

    ,conditionsthatoccurwithprobabilities

    and

    1
    ,respectively.Thus,

    p

    and


    arepositivelyrelated.

    E e
    t
    ( )

    representstheexpectedvalueoftheinitialshockinperiod

    ;because

    isunknowntothecentralbanker,thisequals

    1
    .
    Becausethechoiceofwhethertooptforaruleordiscretioninaperiod
    dependsonthemagnitudeoftheshockinthatperiod,thepublicdoesnotknow
    inadvancewhatthecentralbankwillchoose.Inpractice,inasysteminwhich
    thecentralbankchangesfrequentlybetweenaruleanddiscretion,inflation
    expectationsmightfluctuateconsiderably.However,therationalexpectations
    assumptionguaranteesthatthepublicunderstandstheeconomicstructure.The
    publicdoesnotfactorcurrentshocksintoitsinflationexpectations,sothe
    expectedinflationrateisconstant,aprobabilityweightedaverageofthe
    expectedinflationrateswitharuleandwithdiscretion.Withthemixedstrategy,
    itnolongerholdsthat

    ,becausethecentralbanknolongertargetstheexpectedinflationrate.Instead,
    whenthecentralbankfollowstheidealrule,itseekszeroinflation,so

    0 +

    .Whenusingdiscretiontocombatalargeshock,thecentralbankcheatsand
    thereisaninflationbias,sothat

    ,asinEquation3.15.Because

    E

    0
    ,theexpectedinflationratecanbecomputedasfollows:
    (3.24)

    1
    ( )



    .
    Equations3.14and3.17cannotbesubstitutedunmodifiedintoEquation
    3.23,thoughtheproblemismerelyatechnicalone.Themixedstrategyimplies
    thatthevarianceofinitialshocksforwhichtheruleapplieswillbelow,whereas
    thevarianceofinitialshocksforwhichdiscretionapplieswillbehigh.Let

    denote

    given

    E e
    t
    ( )
    ,andlet

    denote

    E
    given

    E e
    t
    ( ) >
    .A
    consequenceofthemixedstrategyisthatitisnolongertruethat

    and

    2
    .Withoutamixedstrategy,

    2
    and

    2
    ,with

    2
    >

    2
    .Theroutingofshockstoaruleordiscretiondependingontheirsize,however,
    makesitimpossibletopredictaprioriwhethertheexpectedvalueofthesquare
    ofeffectiveshockswillbesmallerwhendiscretionratherthanaruleisused.The
    mathematicalcomplicationisthat

    Ee
    t
    2

    2

    1
    2
    +

    nolongerimplies

    2
    1 1
    2
    ( )
    [ ]

    2
    .Although

    andboth

    and

    aredirectlycomputable
    7
    ,itisnotthecasethat

    2

    1
    2

    or

    2

    1
    2
    .Thisisbecausetheuseofaruleordiscretioninperiod

    impliestheuseofthe
    sameapproachinperiod

    t 1

    withsomeprobabilitylessthan1.Intheory,itisalgebraicallypossibletorelate

    or

    with

    Ee
    t 1
    2

    given

    Ee
    t
    ,andultimatelysolvefor

    and

    asfunctionsof

    and

    2
    .Thesolution,however,involvescumbersomecalculus
    8
    andisdevoidof
    economicinsight.Consequently,thispaperassumesanapproximaterelationship
    thatcapturesthebehaviorof

    and

    withoutassuminganyparticulardistributionfor

    .Assumingexpressionsfor

    and

    involving

    p

    and

    isunproblematicaslongastheassumptionsreflectinageneralsensewhat
    wouldhappenif

    or

    werechangedwiththeotherheldconstant.(Infact,theoptimalvalueof

    will
    dependon

    2
    ,butthisisirrelevanttothemodelingof

    and

    2
    7
    Itisassumedthat
    ,sincethesehavevaluesregardlessofwhether

    ischoseninanoptimalway.)
    Increasingtheprobabilityofusingtheruleforagivenshockseverityshould
    raise

    andlower

    2
    ,i.e.

    2
    > 0
    and

    2
    < 0
    .Similarly,

    2
    > 0
    and

    2
    > 0
    when

    isheldconstant.Thefollowingassumptionsmeetthesecriteria:
    (3.25)

    2
    ,and

    e
    t

    (3.26)
    isnormallydistributed.Fromthedefinitionofthenormalcurve,itfollowsthat


    1
    ( )

    2
    .
    Equations3.25and3.26behaveappropriatelywhen

    p 0

    and

    p 1

    1
    2

    2
    0

    2
    2

    ,and
    .Forexample,when

    p 0
    ,

    2
    0
    and

    1
    2


    2
    2

    ,where
    .Inthiscase,becausetheruleisusedonlywhen

    Ee
    t
    0
    ,whichoccurswith

    p 0


    ,theexpectedvalueofthesquareoftheeffectiveshockis0also.Likewise,
    becausediscretionisusedallthetime,

    2
    .
    Itisnowpossibletoderive

    and

    tosubstituteintoEquation3.23.Theformulafor

    fromEquation3.24couldbeusedinthese,buttheultimatederivationofthe
    optimalvalueof

    provessimplerif

    istakenasaconstant;

    canthenbecomputedexpostfromEquation3.23ifdesired.Thesetupisas
    before:
    andtheexponentiated

    srepresentthemathematicalconstants3.14159...and2.17828...,not
    inflationandtheinitialshock.
    8
    Cumbersomeisanunderstatement.Theintegralsintheabovefootnotebelongtothefamily
    ofimpossibleintegrals,sothereisnoclosedformsolutionforthem.Anysolutionwouldneedto
    beanapproximation.
    (3.27)

    2
    +



    ( )
    2
    [ ]

    2
    +



    ( )
    2
    [ ]

    '



    Toderive

    ,substitute

    0 +

    for

    andsimplify,yielding
    (3.28)

    1 +
    ( )

    2
    +

    +


    ( )
    2
    .
    Thederivationof

    requiressubstitutionof

    f

    +

    for

    ,yielding
    (3.29)

    1 +
    ( )

    2
    + 1 +
    ( )

    2


    2
    +

    +


    ( )
    2

    2

    +


    ( )
    .
    SubstitutingEquations3.25,3.26,3.28and3.29intoEquation3.23resultsin
    (3.30)

    1 +
    ( )

    2
    +

    +


    ( )
    2
    [ ]
    +
    1
    ( )
    1 +
    ( )

    2
    + 1 +
    ( )

    2


    2
    +

    +


    ( )
    2

    2

    +


    ( )
    [ ]
    Tominimize

    withrespecttotheproxyforcentralbankindependence,solvefor

    when

    0
    .Thesolutionis
    (3.31)

    p
    2 1 +
    ( )

    2
    +
    2


    2
    1 +
    ( )

    2

    +


    ( )
    2 1+
    ( )
    +


    ( )

    2
    .
    Because

    2

    2
    2 1 +
    ( )
    +

    ( )

    2
    > 0
    ,thesecondorderminimizationconditionholds.InEquation3.31,notethat

    f
    2


    2
    1 +
    ( )

    2

    +


    ( )
    > 0
    ,since

    0 <

    <


    isassumedinEquation3.24.AlthoughEquation3.31iscomplicated
    mathematically,twoimportantconsequencesemerge.First,

    2
    < 0
    ,socountrieswithahigherincidenceofshockswillchoosetohavemore
    dependentcentralbanks,aspredicted.Because

    isacontinuousvariablethatisa
    proxyforcentralbankindependence,slightchangesin

    causeonlyslightchangesin

    .Second,becauseinpractice

    0 <

    2
    <
    ,itfollowsthat

    0 < < 1

    isoptimal.Giventheassumptionsofthismodel,acountrywillendowitscentral
    bankwithadegreeofindependencethatisbetweentheextremesoftotal
    dependenceandtotalindependence.
    InbothEquations3.19and3.31,acountrychoosesalevelofcentralbank
    independencebasedonthevaluesofseveralconstantparameters.Itisnotclear,
    however,thatdraftersofacentralbankconstitutionwouldindeedbeawareof
    thevaluesoftheappropriateparameters.Particularlydifficultistheassumption
    thatcentralbankpolicymakerscorrectlyestimate

    and

    c
    ,theeffectivenessofstabilizationwitharuleandwithdiscretion.Arelated
    concernisthepossibilitythatthismodelsassumptionthatdiscretionstabilizes,
    i.e.that

    c >


    ,isincorrect.Perhapscentralbankdependenceincreasesinstability,with

    > 1
    .However,theresultsofEquations3.19and3.31willholdifpolicymakers
    believe

    c > c
    ,whetherornotthisbeliefisaccurate.Thus,ifpolicymakersbelieve

    c > c
    ,andinfactchoosedependenceaccordingtothismodel,thencountrieswith
    arelativelygreatincidenceofshockswillchooserelativelydependentcentral
    banks.Ifthepolicymakersarewrong,and

    c < c
    ,thenthischoiceisunfortunate.
    Policymakershavesacrificedthebenefitsofaruleforaperceivedabilityto
    counteractshockswithdiscretion,whichinfactworsensanyexistinginstability.
    Underthisalternativehypothesis,differingdegreesofindependenceappearonly
    becauseofanincorrectunderstandingofeconomicinstitutions.Thepicturecan
    befurthercomplicatedbysupposingthatcountrieshavedifferentestimatesof

    and

    c
    .Inthiscase,evenifthischaptersmodeliscorrect,itbecomesdifficultto
    empiricallyverifytheaccuracyofitspredictions.
    Chapter4:StudiesofCentralBank
    Independence
    Thereisnothingthatgivesamanconsequence,andrendershimfitforcommand,likea
    supportthatrendershimindependentofeverybodybuttheStateheserves.
    GeorgeWashington
    Thischapterexaminestheliteratureexploringthemeasurementofcentral
    bankindependence,andtherelationshipofindependencetoeconomic
    performance.Theliteraturehasexaminedwhetherindependencehasledto
    inflationbenefitsandwhetherithashadanyeffectspositiveornegativein
    termsofoutputgrowthandstabilization.Thissectionbeginsbydiscussinghow
    independenceismeasured,andthensummarizessomeconclusionsthat
    researchershavemadebasedonthesemeasurements.Theindicatorsof
    macroeconomicperformancerelevanttothispaperareproxiesforstabilization
    policyeffectiveness.Thischapterchallengesastudythatusesthevarianceof
    GNPgrowthasaproxytoconcludethatthereisnorelationshipbetweencentral
    bankindependenceandstabilizationpolicyeffectiveness.ThevarianceofGNP
    growthisanimperfectindicatorofstabilizationpolicyeffectivenessforanumber
    ofreasons.Animportantlimitationisthatthevariancemeasuredoesnot
    disentangletheeffectivenessofstabilizationandtheincidenceofshocks.The
    measureisthusanimperfectindicatorofstabilizationpolicyeffectivenessifthe
    incidenceofshocksishighlyvariableacrosscountries.Thisisaparticular
    probleminthecontextoftheconclusionsofthemodelinChapter3.Because
    centralbanksaremorelikelytobeindependentincountrieswitharelativelylow
    incidenceofshocks,thevarianceofGNPgrowthisabiasedestimateof
    stabilizationpolicyeffectiveness.
    Thispaperreliesonmeasuresofcentralbankindependencethatother
    authorshavedeveloped.BadeandParkin(1980),whoseresultsaresummarized
    inAlesinaandSummers(1993),arethefirsttoprovideanindependenceproxy
    variable,a1to4scalefor12countries,basingtheirratingsonthewordingof
    centralbankconstitutions.Alesina(1988)extendsthisdatasetforanadditional
    fourcountries.Thisrevisedscale,however,reflectsonlythepolitical
    independenceofacentralbank.AnindexbyGrilli,Masciandaro,andTabellini
    (1991)reflectsboththepoliticalindependenceandtheeconomicindependenceof
    acentralbank.Politicalindependencereferstotheabilityofacentralbanktoset
    policyobjectives,suchasinflationtargets,withouttheinfluenceofthe
    government.AsAlesinaandSummersnote,Thismeasureisbasedonfactors
    suchaswhetherornot[thebanks]governorandtheboardareappointedbythe
    government,thelengthoftheirappointments,whethergovernment
    representativessitontheboardofthebank,whethergovernmentapprovalfor
    monetarypolicydecisionsisrequiredandwhetherthepricestabilityobjective
    isexplicitlyandprominentlypartofthecentralbankstatute.(p.153)Itiseasy
    toseehowsuchfactorsmighthaveconsequencesforcentralbankersdeciding
    whethertofollowalowinflationpolicy.Becauseamotivationofpoliticiansisto
    winreelection,theymayheavilydiscountthecostsoffuturepolicies.
    Specifically,eveninBarroandGordons(1983)simpletwoperiodmodel,the
    enforcementcostsofasurpriseinflationarefeltinthefuture.Onecanthus
    imaginealowpoliticaldiscountrate,

    <
    ,whichreflectstheadditionalrateofdiscountthatpoliticiansapplytofuture
    benefitsandcostsrelativetothemedianvoter.Thetemptationtocheatonthe
    idealrule(Equation2.4)isunchanged,buttheenforcementcostsofsuch
    cheating(Equation2.5)fall:
    (4.1)

    enforcement


    +1

    + 1
    ( )


    2
    2
    <

    2
    2
    .
    Theenforcementmechanismmaybelesseffectiveforapoliticianthanforan
    officialactingtominimizesocialloss.Ifgovernmentofficialssitontheboardof
    thecentralbankoriftheexecutivebranchsapprovalisrequiredforconductof
    monetarypolicy,thenalowinflationequilibriumwillbehardertoachieve.
    Similarly,centralbankersappointedbythegovernmentmayfeelrequiredto
    pursuethatgovernmentseconomicobjectives,althoughsuchasenseofpersonal
    dutycouldbetemperedifthebankersaregiventhejobsecurityoflongtermsin
    office.
    Skewedpoliticalpreferencesthusmakethedefinitionofacentralbanks
    politicalindependenceconsistentwiththeassumptionofthemodelinChapter3,
    whichsuggeststhatamoreindependentcentralbankismorelikelytopursuethe
    idealrule.Thereisanadditionalimportantreasonthatcentralbankersmaybe
    moreinclinedtofightinflationwhennotappointedbythegovernment.Anon
    governmentalselectionprocessforcentralbankersmayallowconservative
    financialinterestssomeinfluence.Becauseasurpriseinflationhurtslendersand
    contributestoinstability,suchfinancialinterestsarelikelytofavorconservative
    centralbankers.Totheextentthatsuchcentralbankersmayputarelatively
    greaterweightoninflationstability,theyareperversepolicymakers.AsRogoff
    (1985)suggests,theymaythusbeabletoachievebetterperformance.Ofcourse,
    suchacentralbankercouldbetooconservative;indeed,Rogoffsanalysisimplies
    thatconservativefinancialinterestswouldminimizetheirlossbychoosinga
    centralbankerevenmoreconservativethanthemselves.Also,apoliticianaware
    ofRogoffsanalysiscouldselectaconservativecentralbankereveniffinancial
    interestswerenotinvolvedintheselectionprocess.
    Whilethegovernorsofapoliticallyindependentcentralbankarechosen
    withlittleinfluencefromthegovernment,thefreedomofcentralbankersto
    makedecisionsindependentlyofthegovernmentdependsonabankseconomic
    independence.Aneconomicallyindependentcentralbankfacesfewrestrictions
    onitsabilitytousemonetarypolicyinstruments.Forexample,abankwhich
    mustfinancethegovernmentsdeficitisclassifiedasrelativelydependent.A
    bankinafixedexchangeratecountrywiththepowertorevalueordevaluethe
    currencywithoutexecutivebranchpermissionisrelativelyindependent.The
    moreconstraintsthatacentralbankfaces,themoredifficultyitmighthavein
    pursuingalowinflationpolicy;forexample,ifabankmustfinancethe
    governmentdeficit,itmaybeimpossibletomaintainlowinflation.Theremay,
    however,beadvantagestoeconomicdependence.HealeyandLevine(1992),for
    example,write,Demandmanagementpolicyis[intheory]mosteffectivewhen
    monetaryandfiscalpolicyarecoordinatedas,forexample,whenthecentral
    bankandthegovernmentformallycollaboratetoagree[sic]acommonobjective
    functionandthemostappropriatemixofmonetaryandfiscalpolicies.(p.24)
    Noncooperativeoutcomescanbeefficient,however,particularlywhen,
    AndersenandSchneider(1986)argue,oneoftheplayersisonlyconcernedwith
    oneofthegoalvariables.Inthiscasethenoncooperativeoutcomeisefficient
    andtherearenogainsfromcooperation.(p.187)
    Boththepoliticalandtheeconomicindicesthusprovideproxiesofcentral
    bankindependence.AlesinaandSummers(1993)developanaverageindexof
    centralbankindependence,whichisbasedonBadeandParkin(1980),Alesina
    (1988),andGrilli,Masciandaro,andTabellini(1991).Cukierman(1992)provides
    twoadditionalindicesbasedonlegalvariablesinvariouscentralbank
    constitutions.Cukiermansdataencompassalargenumberofcountries,andare
    basedonalargenumberofcarefullydrawncriteria.Theseindices,whichlikethe
    othersincreasewithindependence,arecalculatedbyexaminingfourdifferent
    aspectsofthewordingofcentralbankconstitutions.Theseincludethe
    appointmentandindependenceofthechiefofthecentralbank,thegovernments
    participationintheformulationofmonetarypolicy,thestatedobjectivesof
    centralbankpolicy,andlimitationsoncentralbanklending.Thesecriteria
    includebothpoliticalandeconomicvariables.Forexample,Cukiermanexamines
    howdifficultitistodismissthechiefexecutiveofficerofacentralbank,a
    politicalconsideration,aswellaswhetherthecentralbankmustprovidecredit
    tothefiscalauthorities,aneconomicone.Aproblemwithdevelopmentofany
    indexbasedonlegalvariablesistheweighttoplaceoneachinstitutional
    variable.Cukiermanstwoindicesreflectdifferentweightings.Oneindex,which
    islistedonlyinCukierman,Webb,andNeyapti(1992),reflectsCukiermans
    purelysubjectiveweights,andtheotherweightsequallyeachofhisfourmajor
    categories.Table4.1reportstheseindicesofcentralbankindependence,along
    withtheindicesdevelopedbyotherauthorsdescribedabove.
    Table 4.1: Constitution-Based Indices of Central Bank
    Independence
    This table provides indices of central bank independence for the twenty-three
    countries that the International Monetary Fund (1993) classifies as industrialized. All
    indices have higher values for more independent banks. The first column presents
    the Bade and Parkin index, extended by Alesina on a scale from 1 to 4. The second
    and third columns show the Grilli, Masciandaro, and Tabellini index of political
    independence and economic independence, each on a scale from 0 to 7. The fourth
    column sums the second and third columns. The fifth column, developed by Alesina
    and Summers, is a weighted average of the first and fourth columns. The sixth
    column is Cukiermans index of legal central bank independence based on equal
    weighting between his four main categories. The seventh column is an index,
    published in Cukierman, Webb, and Neyapti, reflecting Cukiermans subjective
    judgments about the importance of various categories. The scale ranges for both
    columns six and seven are from 0.0 to 1.0. An entry is left blank if the relevant scale
    did not include a value for that country.
    Country BP GMTP GMTE GMT AS CEW CSW
    Australia 1 3 6 9 2 0.31 0.36
    Austria 3 6 9 0.58 0.61
    Belgium 2 1 6 7 2 0.19 0.17
    Canada 2 4 7 11 2.5 0.46 0.45
    Denmark 2 3 5 8 2.5 0.47 0.50
    Finland 0.27 0.28
    France 2 2 5 7 2 0.28 0.24
    Germany 4 6 7 13 4 0.66 0.69
    Greece 2 2 4 0.51 0.55
    Iceland 0.36 0.34
    Ireland 3 4 7 0.39 0.44
    Italy 1.5 4 1 5 1.75 0.22 0.25
    Japan 3 1 5 6 2.5 0.16 0.18
    Luxembourg 0.37 0.33
    Netherlands 2 6 4 10 2.5 0.42 0.42
    Norway 2 2 0.14 0.17
    N. Zealand 1 0 3 3 1 0.27 0.24
    Portugal 1 2 3 0.41
    Spain 1 2 3 5 1.5 0.21 0.23
    Sweden 2 2 0.27 0.29
    Switzerland 4 5 7 12 4 0.68 0.64
    United Kingdom 2 1 5 6 2 0.31 0.27
    United States 3 5 7 12 3.5 0.51 0.48
    Sources: Grilli, Masciandaro, and Tabellini (1991), Alesina and Summers (1993), Cukierman
    (1992), Cukierman, Webb, and Neyapti (1992)
    Astheircreatorsgenerallyadmit,indicesofcentralbankindependence
    basedonlegalvariablesarelimited.Alloftheseindicesfocusonthewordingin
    centralbankstatutes,notonthedynamicsofmonetarypolicyinpractice.A
    countrythatisindependentonpapermightinfactfacerealconstraintsif
    legislatorsoftenthreatentorevokethebanksindependenceshouldthebank
    refusetoeasemonetarypolicy.Also,countriespastexperienceswithinflation
    arelikelytoaffectpoliticalpreferences,sothatpoliticiansinacountrywitha
    historyofhyperinflationmightrefrainfromcriticizingapolicyoftightmoney.
    AsCukiermannotes,Factorssuchastraditionorthepersonalitiesofthe
    governorandotherhighofficialsofthebankatleastpartiallyshapetheactual
    levelof[centralbank]independence.(p.383)Inresponsetothisproblem,
    Cukiermandevelopsseveralindicesofcentralbankindependencethatdonot
    dependoncentralbankconstitutions.Oneindicatorisbasedontheturnoverrate
    ofcentralbankgovernors,withgreaterturnoverinterpretedasimplyingamore
    dependentcentralbank.Rapidturnoverpresumablycreatesdependence,
    Cukierman,Webb,andNeyaptinote,asbankgovernorseffectivelybecome
    shorttermpoliticalappointments.
    Inanalternativeattempttoquantifyactualindependence,Cukierman
    compilestheresultofasurveyofindividualsatthecentralbanksofvarious
    countries.Thesurveyqueriesofficialsonissuesliketheextenttowhich
    limitationsonlendingareadheredtoinpractice,andhowimportantprice
    stabilityranksinpracticeasanobjectiveofmonetarypolicy.Aswithhis
    constitutionbasedindicesofindependence,Cukiermanprovidestwo
    questionnairebasedindices,onebasedonequalweightingofvariouscategories,
    andtheotherbasedonsubjectiveweighting.Theprincipalproblemwiththe
    approachofthesetwoindicesisthatdataareavailableforonly10ofthe
    countriesrepresentedinTable5.1.Anotherdifficultyisthatnotonlyare
    questionnaireresponsessubjective,butcentralbankofficialsmayalsohavean
    incentivetoexaggeratetheindependenceoftheircentralbanks,forexampleto
    improvetheirreputations.
    Cukiermancombineshisvariousindicesofcentralbankindependence
    intooneoverallindexofcentralbankindependence.Theweightingofeachof
    theindicesisdeterminedbythesignificanceoftheindexinexplainingtherateof
    depreciationinthevalueofacountryscurrencyinthe1980s
    9
    .Specifically,the
    indexconsistsoffittedvaluesfromaregressionofthedepreciationrateagainst
    variousindicesofindependence.Thisisatechnicallynonarbitraryprocedure,
    guidedonlybytheassumptionthatmoreindependentcentralbankshavelower
    inflation,anassumptionverifiedlaterinthischapter.However,thereisno
    reasonthatanindexwhichprovidesapredictorofcurrencydepreciationwill
    alsobeagoodpredictorofstabilizationpolicyeffectiveness.Afurtherproblemis
    thatCukiermanprovidesdataonlyforalimitedsubsetofcountries.Table4.2
    providesCukiermansfournonconstitutionbasedindicesofcentralbank
    independence.
    9
    Thisiscomputedviatheinflationoverthatperiod.Specifically,thedepreciationrateisdefined
    as /(1+ ).Forexample,acountrywith100percentinflationoverthedecadehasadepreciation
    rateof0.5.
    Table 4.2: Additional Indices of Central Bank Independence
    This table provides additional indices of central bank independence. The first
    column indicates the probability that a central banks governor stays in a given
    year. The second and third columns reflect questionnaire results on central bank
    independence. The fourth column is an overall index of central bank independence.
    It is derived by subtracting Cukiermans index (p. 434) from 1.0. All indices thus
    range from 0.0 to 1.0, increasing in independence. Entries for which no data are
    available are left blank.
    Country CGT CQE CQS COI
    Australia 0.73 0.76 0.92
    Austria
    Belgium 0.87 0.53 0.47
    Canada 0.90 0.94
    Denmark 0.95 0.70 0.73 0.96
    Finland 0.87 0.75 0.78
    France 0.85 0.65 0.65 0.91
    Germany 0.90 1.00 1.00 0.95
    Greece 0.82 0.89
    Iceland 0.97 0.89
    Ireland 0.85 0.51 0.57
    Italy 0.92 0.76 0.73
    Japan 0.80
    Luxembourg 0.92 0.67 0.66
    Netherlands 0.95
    Norway 0.92 0.94
    N. Zealand 0.85 0.90
    Portugal
    Spain 0.80 0.90
    Sweden 0.85 0.93
    Switzerland 0.87
    United Kingdom 0.90 0.60 0.64 0.93
    United States 0.87 0.94
    Source: Cukierman (1992)
    Onelimitationofanyproxyofcentralbankindependenceisthatit
    assumesconstantindependenceovertime,whileinfactcentralbank
    constitutionsmaychangefromtimetotimeandthedynamicsofmonetary
    policyareinconstantevolution.AlesinaandSummers(1993)notethat
    constitutionalchangesarerare.Drasticchangesdooccur,however;foracase
    study,seeEpsteinandSchor(1989).Theendogeneityofcentralbank
    independenceinthemodelofChapter3complicatestheproblem.Themodel
    impliesthatacountrysdegreeofcentralbankindependenceshoulddependon
    theincidenceandseverityofshocksatthetimetheconstitutionforthecentral
    bankiswritten.Supposethatthevarianceofdemanddisturbanceschanges
    rapidlyovertime,andthatcentralbankindependenceremainsrelatively
    constantonlybecauseofinstitutionalinertia.Then,theconsiderationofcentral
    bankindependenceasexogenousisunproblematic.Thispaperassumesthatif
    shockseverityweretochange,thatacountrywouldrespondbychangingthe
    degreeofcentralbankindependence.Thelackofsuchchangeswouldthus
    suggestthattheincidenceofshocksisrelativelyconstant.
    Indicesofcentralbankindependencemakeitpossibletotestforvarious
    linksbetweenindependenceandeconomicperformance.Anindependentcentral
    bankmightachievebettereconomicperformancethanadependentoneby
    insulatingconservativecentralbankersfrompublicpressures.Centralbankers
    arenotaffectedbytheallegedpoliticalbusinesscycles,inwhichpolicymakers
    haveincentivestocreatesurpriseinflationsbeforeelections.Theindependence
    perseofacentralbankcouldgivethebankerspoliciesmorecredibility.The
    publicmayrecognizethatthecentralbankersarerelativelyinflationaverse,and
    thattheindependenceguaranteesthatacentralbankerwillnotbowtopublic
    pressure.Also,becausecentralbankersareindependentoffiscalauthorities,they
    areunlikelytoinflatesimplytocreateseignoragerevenue.Ontheotherhand,
    onemightsupposethatacentralbankersensitivetopublicsentimentwouldbe
    moreinclinedtofightunemploymentandthusimproveeconomicperformance
    atleastintheshortrun.Inaddition,asthemodelofChapter3suggests,
    independentcentralbanksmaybeunwillingtorespondtoshocksandthus
    suffermoreseverebusinesscycles.Determiningtherealeconomicconsequences
    ofcentralbankindependencethusrequiresempiricalinvestigation.
    Thetendencyofcountrieswithmoreindependentcentralbankstohave
    betterinflationperformanceiswidelyacknowledged,atleastfortheindustrial
    countries.Grilli,Masciandaro,andTabellini(1991),forexample,examineOECD
    data,andfindsignificanteffectsofcentralbankindependenceoninflation
    performance,particularlysince1970,wheninflationhasbeenhighandvariable.
    10
    Banaian,Laney,andWillett(1983)assessthemechanismunderlyingthistrend
    byestimatingcentralbankreactionfunctionsfor12countries.Theyconclude
    thatmonetarypolicywaslessaccommodativeoverallinthecountriesinwhich
    thecentralbankhasbeencharacterizedasmoreindependent.(p.11)Similarly,
    Burdekin(1987)attributeslowinflationinSwitzerlandtotheindependenceof
    theSwissNationalBank,viathemechanismofanonaccommodativemonetary
    policy.Althoughthehighlevelofinflationobservedincountrieswithdependent
    centralbanksisconsistentwiththemodelofChapter3,
    11
    theincreasedvariability
    ofinflationinthosecountriespresentsachallenge.Themodelassumedthatfora
    givenlevelofshocks,acountrywithadependentcentralbankwouldhavea
    lowervarianceofinflation.Thismaysuggestthatinfact

    > 1
    ,i.e.thatdependentcentralbanksworsen(orcause)shocksratherthancuring
    them.Analternativeexplanationdependsonthemixedstrategymodel
    developedinthesecondhalfofthechapter.Becausethelevelofinflationis
    bimodal,acountrywillbepredictedtohavehighinflationvariancethecloseris

    10
    Cukierman,Webb,andNeyapti(1992)findthatthisrelationshipdoesnotholdinthe
    developingcountries,whereotherfactorsarebetterpredictorsofinflation.
    11
    Thesefindingscould,however,simplyreflectdifferentpreferencesforinflationacross
    countries.Legalbasedindicesofindependenceconsiderwhethertheconstitutionincludesa
    pricestabilitymotive.Whethersuchastatementinfluencescentralbankersorsimplyreflects
    nationaltastesisanopenquestion.
    to0.5.If

    forallcountriesisgreaterthan0.5,thencountrieswithmoredependent
    centralbankscouldhavelargeinflationvariability.Finally,asCukierman(1992)
    notes,apositivecorrelationbetweenthemeanandvarianceofinflationhaslong
    beenobserved.Inanycase,asalreadyindicated,Chapter3,thoughframedinan
    inflationcontext,isintendedtomodeloutputstability.
    Posen(1993)acknowledgesthecorrelationbetweencentralbank
    independenceandlowinflationinindustrialcountries,butarguesthatthereis
    noevidenceforanyoftheproposedmechanismsthatsupportsacausallinkage.
    Posendevelopsamodelinwhichstrongfinancialinterestsopposeinflation,
    leadingtobothcentralbankindependenceandlowinflation.Theassumption
    motivatingtheanalysisisthatthelessindependentthecentralbankis,the
    greaterthepoliticalcostthe[electedgovernment]hastopay.(p.21)Posenfinds
    empiricalsupportforhispropositionbyshowingthatthestrengthoffinancial
    institutionsisaneffectivepredictorofbothinflationandindependence.A
    separatepossibilityininterpretingthecorrelationbetweenindependenceand
    inflationisthathighinflationmaycauselowindependence;indeed,Cukierman
    (1992)determinesthatsuchreversecausationpartiallyexplainsthecorrelation.If
    centralbankindependencedoesnotevencauselowinflation,thenitishardto
    imaginethatcentralbankindependencehasanyrealeconomicbenefits,since
    suchpostulatedbenefitsariseviaimprovedinflationperformance.To
    demonstrateacausallinkbetweencentralbankindependenceandrealeconomic
    performance,onemustbothidentifyandexplainacorrelation.
    Sofar,theliteraturehasbeenunabletodoeitherconclusively.Regressing
    centralbankindependenceagainstoutputgrowth,Grilli,Masciandaro,and
    Tabellini(1991)andAlesinaandSummers(1993)findnosignificantrelationship.
    Otherstudiesattempttocontrolforstructuraldifferencesbetweencountries,
    withmixedresults.DeLongandSummers(1992)adjustforconvergenceeffects,
    i.e.thetendencyofcountrieswithlowinitiallevelsofoutputtogrowfasterthan
    countrieswithhighinitiallevelsofoutput.Controllingforthe1955levelofreal
    outputperworker,DeLongandSummersfindthatcentralbankindependence
    issignificantlycorrelatedwithanincreaseinthegrowthrate.Astudyby
    Cukierman,Kalaitzidakis,SummersandWebb(1993)reachesacontradictory
    result.Thestudyfindsnogrowthbenefitfromindependenceintheindustrial
    economiesaftercontrollingforschoolenrollmentratesandtermsoftrade
    changes,inadditiontoacountrysinitialGDP.
    Eveniftheliteratureweretoisolatesomecorrelationbetweencentral
    bankindependenceandeconomicperformance,theconnectionstillrequires
    explanation.IndeedifPoseniscorrectthatstrongfinancialinterestsarethe
    dominantcauseofcentralbankindependence,thenitiseasytoseehow
    independenceandoutputgrowthcouldbecorrelatedwithoutacausal
    mechanismfromindependencetogrowth.Countrieswiththemostrobust
    growthratesarelikelytodevelopstrongfinancialsectors.Thus,economic
    performanceindirectlybringsaboutcentralbankindependence,viathe
    intermediaryofpowerfulfinancialinterests.Otherscenariosarepossible.For
    example,perhapscountrieswithstrongeconomieshavethemostdeveloped
    bureaucracies.Countrieswithcomplexinstitutionsmaybemorelikelytodrawa
    firmlinebetweenfiscalandmonetarypolicysimplybecausethebureaucratic
    mindsetistoseparatefunctionsofgovernmentintothesmallestpossible
    independenttasks.Thesimplestwayofplacingfiscalandmonetarypolicyin
    completelyseparatebureaucraciesiscreationofanindependentcentralbank.
    Attemptingtodiscernanimpactofinstitutionsonrealeconomic
    performanceisthusdifficultwhenperformanceismeasuredasaverageoutput
    growth.Perhaps,however,identifyinganalternatemeasurementofeconomic
    performancewouldbelessproblematic.Monetarypolicypresumablyhasatleast
    twooutputgoals:first,toencouragelongtermeconomicgrowth;andsecond,to
    reducefluctuationsinoutputarounditsnaturallevel.Evenifcentralbank
    independencehasnoeffectonoutputgrowth,itcouldconceivablyallowor
    preventquickerdissipationofshocks.AlesinaandSummers(1993)regress
    centralbankindependenceagainstthevarianceinrealGNPgrowth,andfindno
    relationship.AlesinaandSummersconcludethatthemonetarydiscipline
    associatedwithcentralbankindependence...doesnothaveeitherlargebenefits
    orcostsintermsofrealmacroeconomicperformance.(p.159)
    Therearereasonstoquestionthisconclusion.Manyfactorsinfluence
    stabilizationpolicyeffectiveness,andtheAlesinaandSummersdatasetissmall
    enoughthatitmightbedifficulttoidentifytheconsequencesofanyonefactor.
    Moreimportantly,evenwithalargesample,thereareproblemswithusingthe
    varianceofGNPgrowthmeasure.Anidealwaytoassesstheeffectofcentral
    bankindependenceonstabilizationperformancewouldbetodirectlymeasure

    2
    thevarianceofoutputaroundthenaturallevelwhilecontrollingfor
    disparitiesintheseverityofshocks.Thereareatleastthreeproblemswith
    AlesinaandSummersuseof

    2
    thevarianceofoutputgrowthasasubstitute.First,

    isaffectedbydifferentialseverityofshocks.Thisislikelytobeaparticular
    problemifshockseverityandcentralbankindependencearerelated.Second,

    measuresthevariabilityofoutputgrowth,while

    measuresthevariabilityoftheoutputlevel.Theseareconceptuallydifferent,and
    indeedneednotbepositivelycorrelated.Third,the

    measurementincludesshocksto

    Y
    n
    ,whichoughtnotbeinterpretedasinefficientstabilization.Theremainderofthis
    chapteraddressesthesethreeissuesinturn.
    UsingthevarianceofrealGNPgrowthasameasureoftheeffectivenessof
    stabilizationpolicyisproblematicifoneeconomysuffersshocksofgreater
    severitythananother.InFigure4.1,CountryAandCountryBarethesameasin
    Figure3.2,exceptthatCountryAsuffersamoresevereshock.Inthiscase,
    althoughoutputdeviatesfromlongrunaggregatesupplyforonlyoneperiodin
    CountryA,thevarianceofoutputishigherthaninCountryBbecauseofthe
    severityoftheshock.ThevarianceofrealGNPgrowthmeasurereflectsnotonly
    stabilizationpolicyeffectiveness,butalsoshockseverity.Thisisaproblemif,as
    inFigure4.1,thereisasignificantdifferenceinshockseverity.
    Figure 4.1: Shock Variability and Output Variance
    As in Figure 3.2, both Country A and Country B experience a positive demand shock,
    but this time, Country As shock is stronger than Country Bs. As a result, the
    variance of output in Country A (measured relative to long-run aggregate supply)
    may be as great as or greater than the variance in Country B, even though Country
    As stabilization policy is more effective than Bs.
    Country A
    (Perfect Stabilization)
    22
    YPLRAS AS AD = AD
    10
    Y ,
    Y
    01
    YAD
    2
    YPLRAS AS AD AD = AD
    10
    Y
    021
    Y ,
    Y
    Country B
    (Neutral Stabilization)
    Moreover,thispaperarguesthatcentralbankindependencemaybe
    endogenouslyrelatedtoshockseverity.ThisimplicationofthemodelinChapter
    3exacerbatestheproblemwiththeuseoftheGNPvarianceindicator.Notonly
    istheindicatorpronetoerror,butitmayalsobebiased.Supposethatcountries
    withindependentcentralbanksareleastlikelytosuffershocksthatcauseoutput
    tovaryarounditslongruntrend,asthemodelofChapter3showsisplausible.
    Suchascenariowouldrenderanyconclusionthatthereisnoassociationbetween
    independenceandvarianceofrealGNPgrowthinvalid.Centralbank
    dependencemightlowerthevarianceofrealGNPgrowth,butbecausecentral
    banksareendogenouslyindependentincountrieswithlowinitialvariancesof
    realGNPgrowth,theplotmissestheeffect.Differentialshockseverityadds
    noisetothevariancemeasurewhetherornotthetheoryofChapter3iscorrect;if
    thetheoryiscorrect,thenoiseisaddedinawaythatbiasesAlesinaand
    Summerstest.
    Regardlessofwhethercountriessuffershocksofdifferingseverity,the
    goalofstabilizationpolicyistopreventadepartureofoutputfromitsnatural
    level,nottokeepgrowthratesconstant.Thisdistinctionisparticularlycriticalin
    amodelinwhichthereissomefundamentalshocktooutputineachperiod.For
    example,consideraneconomythatgrowsonaverage3percentperyear.
    Supposeashockchangesthegrowthrateinagivenyearto1percent.A
    stabilizationpolicythatisperfectwithrespecttogrowthratesreturnsthe
    economytoa3percentgrowthrateinthefollowingyear.Inthiscase,however,
    thelevelofoutputisstillroughly2percenttoolow.Astabilizationpolicythatis
    perfectwithrespecttotheoutputlevelwouldcausegrowthtorisetoabout5
    percentinthesubsequentyear.TheAlesinaandSummersvariancemeasure
    ratesthestabilizationpolicythattargetsgrowthhigherthanthepolicytargeting
    theoutputlevel,eventhoughintuitivelythelatterpolicyismoreappropriate.
    Indeed,usingavariantofthemodelofChapter3,itispossibletoshowthatthe
    varianceofgrowthmeasuremightaccordnobenefittoperfectoverneutral
    stabilization.Suppose,forexample,that
    (4.2)

    Y
    t

    +
    1
    ,
    where

    Y
    t

    isthelogarithmofoutputinperiod

    Z
    t

    isashocktooutput,and


    isaconstantindicatingtheeffectivenessofstabilization.Let

    y
    t
    ,thegrowthrateofoutput,bedefinedas

    Y
    t

    1
    .Itfollowsthat
    (4.3)

    y
    t

    1 ( )
    1

    2
    .
    Since

    representsperfectstabilizationand

    representsneutralstabilization,itfollowsthat
    (4.4)

    2
    2

    2
    ,
    bothwithperfectandneutralstabilizationpolicy.Moreover,intuitioncanbe
    reversed;forexample,

    isgreaterwhen

    0. 25

    thanwhen

    0. 5
    .ThisisincontrasttoadirectmeasureofthevarianceofGNP,
    (4.5)

    2
    1 +
    2
    ( )

    2
    ,
    whichcorrectlyreflectsthebenefitsofperfectstabilization.Thisargumentdoes
    notprovideaneasyalternativetoAlesinaandSummersapproach,however,
    becauseofthethornyempiricaldifficultiesinmeasuringdetrendedGNP.
    However,thisargumentismeantasacaution,notasaproofthatthevarianceof
    GNPgrowthwillneverbepositivelycorrelatedwithanmeasureofthevariance
    ofGNPthatadjustsforgrowthovertime,asAlesinaandSummersimplicitly
    assume.Indeed,inthisexample,

    2
    > 0
    when

    0. 5 1
    ,sothistheoreticalconcernmaynotbeaprobleminpractice.
    AfinalcomplicationwiththevarianceofrealGNPgrowthmeasureisthat
    supplyshocksmaychangethenaturallevelofoutput.Perfectstabilizationafter
    eitherademandorasupplyshockreturnsoutputinthenextperiodtothe
    naturallevel.Measuringthevariabilityofoutputisthusanappropriateproxyof
    stabilizationonlyiftherearenosupplyshocks,asinthemodelofChapter3.The
    hypotheticalexampleinFigure4.2showstwowaysthatthevariabilityofoutput
    growthmeasurecandeceive.CountryAhasaperfectstabilizationpolicy;
    aggregatedemandshiftstoreturntheeconomytoitslongrunequilibriumone
    periodafterasupplyshock.Thevariabilityofoutputaroundthenaturallevelis
    lowasaresult,butthevariabilityofoutputandthevariabilityofoutputgrowth
    arehigh.InCountryB,anaggregatedemandshockisunmitigatedinthesecond
    period.Thevariabilityofoutputaroundthenaturallevelishigh,butthe
    variabilityofoutputandoutputgrowtharelowerthaninCountryA.
    Figure 4.2: Demand vs. Supply Shocks
    Country A, at left, experiences a positive supply shock. The long-run aggregate-
    supply curve, which represents the natural level of output, shifts out to reflect the
    economys increased productive capacity. The short-run aggregate-supply curve
    overshoots long-run aggregate-supply in the short run. Because Country A has a
    perfect stabilization policy, however, an aggregate demand shift returns the
    economy to the long-run equilibrium level in the next period. Country B, at right,
    experiences a positive demand shock. Because stabilization in the country is
    neutral, aggregate demand does not return to the long-run equilibrium in the next
    period. Note that the variability of the output level is about the same in both
    countries.
    Country B
    (Positive Demand Shock,
    Neutral Stabilization)
    LRAS
    Y
    P
    AS
    E
    0
    E
    1
    AD
    0
    1
    AD
    2
    =AD
    =E
    2
    Y
    0
    Country A
    (Positive Supply Shock,
    Perfect Stabilization)
    LRAS
    1
    1
    Y Y
    0
    1
    AS
    Y
    P
    AS
    0
    LRAS
    0
    E
    0
    E
    1
    0
    AD
    1
    =AD
    2
    AD
    Y
    2
    E
    2
    Chapter5:MeasuringStabilization
    Performance
    Whenyoucanmeasurewhatyouarespeakingabout,andexpressitinnumbers,you
    knowsomethingaboutit.
    WilliamThompson
    TheanalysisofChapter4suggeststhatthevarianceofGNPgrowthisan
    imperfectproxyofstabilizationpolicyeffectiveness;developmentofan
    alternativemeasureisthusneeded.Thischapteroutlinesthreeapproachesto
    measuringstabilizationpolicyeffectivenessthattakeintoaccountChapter4s
    criticismsofthevarianceofGNPgrowthmeasure.
    12
    Twooftheseapproachesalso
    implywaystomeasuretheseverityofshocks,makingitpossibletotestthe
    predictionofChapter3smodel.Animportantcaveattothethreestabilization
    measuresisthattheydonotprovidemeasuresofcentralbankstabilization
    policyeffectiveness,butoftheeconomyscombinedcapacityforstabilization.
    Forexample,ameasuredevelopedinthischaptermightindicatepoor
    stabilizationeffectiveness,butthatineffectivenessmightbeduetoerraticfiscal
    policy.ThethrustofChapter6isanalysisofregressionsofthestabilization
    measuresdevelopedinthischapteragainstthecentralbankindependence
    indicesdiscussedinChapter4.Thedatacomputedinthischaptercouldalsobe
    12
    ThecriticismsofChapter4wouldcontinuetoberelevantifthevarianceofGDPgrowthwere
    substitutedforthevarianceofGNPgrowth.Grossdomesticproductfiguresaremore
    appropriate,however,sincestabilizationpoliciesforagivencountryaffectforeignfirmswithin
    thecountrymorethanexpatriatefirmsfromthecountry.GDPratherthanGNPfiguresareused
    togeneratethedatainthischapter.
    usedtoexploreotherissues,suchastherelationshipbetweenpoliticalinstability
    andsuccessateconomicstabilization.
    Thereisatradeoffbetweenthesimplicityofameasureofstabilization
    policyeffectivenessandtheextenttowhichitaddresseseconomicconcerns.The
    measurespresentedlaterinthischapteraremorecomplexthantheearlierones,
    buttheselessintuitivemeasuresgenerallycompensatebybetteraddressingthe
    problemsdescribedinChapter4andbymoreaccuratelymodelinganeconomys
    dynamics.Allthreeapproachesattempttomeasurestabilizationpolicy
    effectivenessbyestimatingthepersistenceofshockstooutput.Ifoneperiods
    outputfluctuationdependsheavilyontheextenttowhichoutputintheprior
    perioddeviatedfromthetrend,thenstabilizationpolicyisrelativelyineffective,
    asitisunabletoneutralizeshocks.If,ontheotherhand,thereisnorelation
    betweenthemagnitudeanddirectionofoneperiodsfluctuationandtheprior
    periods,thenstabilizationpolicyiseffective.Specifically,recallfromEquations
    3.7and3.8that


    1
    +

    ,while


    1
    +

    .Thedeviationofinflationfromthelevelcorrespondingtothenaturalrateof
    unemploymentdependsonthepreviousperiodsinflationshockandanew
    fundamentalshock.Because

    < 1

    isassumed,thepreviousperiodsshockispredictedtobealesssignificant
    determinantofthecurrentperiodsshockincountrieswithdependentcentral
    banks.Ifadependentcentralbankisabletoachieveperfectstabilization,then

    andshockstoinflationshouldbeuncorrelatedfromoneperiodtothenext.
    WhilethemodelofChapter3addressedshockstoinflation,theassumptionthat
    therearenosupplyshocksguaranteedthattheseshockshaddirectoutput
    analogs.Becauseofthispapersfocusonoutputstabilization,thischapter
    attemptstomeasuretheenduranceofshocksoutputratherthaninflation
    consequences.Anextensiontothispapermightbetomodifythemeasuresso
    thattheyassessthevariabilityininflationratherthanoutput.
    Thischaptersmeasuresdifferinhowtheydefinedeviationsfromtrend.
    Thefirstmeasureconsidersanydeviationoftheoutputlevelfromtrendtobea
    shock,andcomputestheserialcorrelationoftheseshocks.Thisapproach
    controlsforthedifferentialincidenceofshocksacrosscountries,andassesses
    stabilizationoftheoutputlevelratherthanofthegrowthrate.Thesecond
    measureimprovesonthefirstbyusingarichermodelingofthepersistenceof
    shocks;inparticular,themeasureconsidersashocktobeachangeinoutput
    growththatrecentoutputgrowthandinflationratesdonotpredict.This
    measure,however,doesnotdistinguishbetweenstabilizationoftheoutputlevel
    andgrowth.Thefinalmeasureincorporatesstillmoreofaneconomysdynamics
    viaavectorrepresentationofbothoutputandprices.Thismeasurealso
    addressesallthreeofChapter4scritiques,includingtheeffectofsupplyshocks
    onthenaturallevelofoutput.
    Tocomputeameasureoftheserialcorrelationofoutput,anindexofreal
    GDPwasregressedagainsttime.TheDurbinWatsonstatisticfortheregression
    providesanindicatoroftheserialcorrelationofoutputaroundthetrendline.
    TheuseofrealGDPfiguresensuresthatthevariabilityinoutput,notthe
    variabilityingrowthrates,ismeasured.TheDurbinWatsonstatisticis
    approximatelyequalto

    2 1


    ( )
    ,where


    isanestimateoftheserialcorrelationcoefficient.Thus,


    wasapproximatedfromthisformulaforeachcountrytoprovideanindicatorof
    serialcorrelationinwhichlownumbersindicatebetterstabilization.Valuesof


    relativelyclosetozerothusindicateeffectivestabilization.Eachestimateof


    wasgreaterthan0.5,indicating,asexpected,thatallcountriesexperienced
    considerablepositiveserialcorrelation.Table5.1providesthesestatisticsforthe
    industrializedcountries.
    Table 5.1: Serial Correlation of Real GDP
    This table represents the serial correlation of real GDP. Each number is an estimate
    of a countrys serial correlation coefficient, equal to half of 2 the Durbin-Watson
    statistic for a regression of real GDP against time. Higher numbers represent greater
    serial correlation, and thus less effective stabilization. Data are derived from
    International Monetary Fund (1993).
    Country SC Country SC
    Australia 0.737 Japan 0.866
    Austria 0.796 Luxembourg 0.801
    Belgium 0.849 Netherlands 0.905
    Canada 0.690 Norway 0.837
    Denmark 0.684 N. Zealand 0.831
    Finland 0.688 Portugal 0.696
    France 0.860 Spain 0.917
    Germany 0.785 Sweden 0.749
    Greece 0.901 Switzerland 0.830
    Iceland 0.672 United Kingdom 0.770
    Ireland 0.813 United States 0.623
    Italy 0.551
    AlimitationofthedatainTable5.1isthatitdoesnotfullycapturethe
    dynamicsofoutputandinflationshocks.Itincorrectlyassumesthatthe
    deviationofoutputfromfullemploymentissimplyafirstorderautoregressive
    process.Inreality,deviationsofoutputandinflationfromtrendareinterrelated.
    Thelevelofoutputinaperioddependsmainlyonalongtermtrend,butalsoon
    thelevelofoutput,inflation,andothereconomicaggregatesinthepastfew
    periods.Forexample,supposethatinagiventimeperiod,outputinacountryis
    atthenaturalratebutinflationishigh.Tocombatinflation,thecentralbank
    mightraiseinterestrates,andthuslowerthelevelofoutputinsubsequent
    periodsbelowthenaturalrate.Ifstabilizationpolicyisperfect,thendeviationsof
    outputfromtrendinatimeperiodshoulddependneitheronoutputdeviations
    inthepastperiodnoronthepastperiodsinflationrate.Ifstabilizationisneutral,
    theninflationandoutputinpastperiodsshouldbepowerfulpredictorsofboth
    suchvariablesinthecurrentperiod.Supposethatthegrowthofoutputinone
    perioddependsonthegrowthofoutputandtheinflationrateinthepriortwo
    periods.Then,
    (5.1)

    y
    t
    +
    1

    1
    +
    2

    2
    +
    3

    1
    +
    4

    2
    +

    ,
    where

    y
    t

    representsthefirstdifferenceofthelogarithmofrealGDPand

    p
    t

    representstheinflationrateinperiod

    .Theconstant


    andthe


    parameterscanbeestimatedforeachcountrywithanordinaryleastsquares
    regression.The

    parameterisaresidualthatmeasuresthecontemporaneousshockstothegrowth
    rateofGDP.The


    and


    parameterscapturethedynamicsduetopastshocks.Thefollowingargument
    explainshowthisdistinctionmakesitpossibletoproducemeasuresofboth
    stabilizationpolicyeffectivenessandofshockseverity.
    Let

    y
    t

    bethefittedvalueof

    y
    t
    ,definedasfollows:
    (5.2)

    y
    t


    +


    1

    1
    +


    2

    2
    +


    3

    1
    +


    4

    2
    ,
    13
    where


    andthe


    parametersaretheregressionestimatesof


    andthe


    parametersfromEquation5.1.Equation5.2providesanautoregressivereduced
    formmodeloftheeconomy.Themodelmakesnoaprioriassumptionsabout
    economicstructure.Forexample,themodeldoesnotassumethatinflationinone
    periodislikelytoresultinlowerGDPgrowthinthesubsequentperiod.Theonly
    assumptionisthatpastvaluesofGDPgrowthandinflationaregoodpredictors
    ofcurrentGDPgrowth.Effectively,Equation5.2providesausefulbasisfor
    predicting

    y
    t

    withdatainperiods

    t 1

    and

    t 2
    .Theapproachislimitedinthatsomestabilizationmayinrealityoccurwithina
    period.Thislimitationisparticularlytroublesomewithannualdata,whichthis
    13
    TheSchwarzBayesinformationalcriteriaforthisregressionconfirmsthatthechoiceoftwo
    lagswasindeedappropriate.TheaverageSchwarzBayesvalueforthecountriesassessedwas
    2.02.Forsomecountries,theoptimallaglengthwasnottwo.However,twolagswereusedfor
    allcountriestoensurecomparabilityofresults.
    paperusesbecauseofthedifficultyincollectingandevaluatingmonthlyor
    quarterlydataforlargenumbersofcountries.However,Equation5.2isusefulto
    evaluatestabilizationbecausepastshocksarelikelytobemorereliable
    predictorsinsomeeconomiesthaninothers.Specifically,supposeacountry
    successfullypursuesperfectstabilizationpolicy.Bydefinition,thecountryisable
    tocompletelyneutralizeshockstoinflationoroutputinpriorperiods.Thus,the
    levelofinflationandthelevelofoutputgrowthinrecentperiodsarenotnearly
    assignificantindeterminingthelevelofoutputinthecurrentperiodasisthe
    averagelevelofoutputgrowthoveralongperiodoftime.
    The

    R
    2

    statisticoftheregressioninEquation5.2isthereforeagoodproxyofthe
    effectivenessofstabilizationpolicy.The

    R
    2

    statisticrepresentsthefractionofthevariabilityinthedependentvariablethat
    canbeexplainedbychangesintheindependentvariables.The

    R
    2

    statisticdoesnottakeintoaccounthowaccurateanestimateofthedependent
    variabletheconstanttermprovides.Thus,inaregressionestimateofEquation
    5.2,ahighvalueof

    R
    2

    indicatesthatvariabilityin

    y
    t

    iswellexplainedby

    y
    t1
    ,

    y
    t2
    ,

    p
    t 1
    ,and

    p
    t 2
    .Thissuggeststhatstabilizationpolicyisrelativelyineffective,becausepast
    shocksaresignificantindicatorsofcurrentshocks.Alowvalueof

    R
    2
    ,incontrast,suggestseffectivestabilizationpolicy.ThemodelofChapter3thus
    suggeststhatforcountrieswithindependentcentralbanks,the

    R
    2

    statisticoftheregressioninEquation5.1shouldberelativelycloseto1,whilefor
    countrieswithrelativelydependentcentralbanks,thestatisticshouldbecloseto
    0.Animportantcaveatisthatthe

    R
    2

    statisticisderivedfromfirstdifferenceddata,andthusisinfactameasureofthe
    stabilizationofgrowthrates,notofthestabilizationofrealGDP.The

    R
    2

    statisticdoes,however,adjustfortheseverityofshocks,becauseitconsiders
    onlythedynamicsofstabilization,representedbythe


    andthe


    parameters,whileignoringtheshockresidual,

    .Notethatwhilethisshockresidualisanalogoustothe

    introducedinthemodelofChapter3,itrepresentsinthiscaseashocktooutput
    ratherthanashocktothepricelevel.Forexpositionalclarityintheargument
    thatfollows,define

    asthe

    encounteredinChapter3,i.e.,asthefundamentalpriceshock.Whenthereare
    onlydemandshocks,the

    parameterisrelatedto

    bytheslopeoftheshortrunPhillipsCurve:

    .
    Intuitionthussuggeststhatthehigherthevalueofthe

    R
    2

    statistic,thelesseffectivestabilization.Thishunchaboutthemeaningof

    R
    2

    canbeverifiedbyexaminingthedefinitionofthestatistic.Bydefinition,
    (5.3)

    R
    2
    1

    ( )
    2


    ( )
    2

    ,
    where

    representstheerrorsumofsquares,

    thetotalsumofsquares,

    theresidualofthefittedregressioninperiod

    ,and

    y
    theobservedmeanvalueof

    .Bydefinition,

    ,so

    y
    t

    .Because

    y
    t

    and

    arestatisticallyindependent,
    (5.4)

    2



    2
    +

    2
    ,andthus

    2
    .
    Thefollowingsamplevariancesprovideunbiasedestimatesofthepopulation
    variancesinEquation5.4:
    (5.5)

    ( )
    2

    5
    ,

    s
    y
    2


    ( )
    2

    1
    ,and

    y
    2


    ( )
    2

    5
    .
    Theconstant

    representsthetotalnumberofobservationsof

    y
    t
    ,notincludingthefirsttwowhichareusedonlyaslaggedindependent
    variables.FromEquations5.3,5.4and5.5,onecanderive:
    (5.6)

    R
    2

    5
    1


    _
    ,

    2
    +
    4
    1
    .
    InthemodelofChapter3,theeffectiveoutputshock,

    z
    t
    ,isdefinedas

    y
    t

    .Because

    y
    isaconstant,

    2
    .Theeffectiveoutputshockisrelatedtotheeffectiveinflationshockby

    z
    t

    ,so

    2
    1
    2
    ( )

    2
    .Butthevarianceofinflationshockscanberelatedtotheeffectivenessof
    stabilizationpolicyby

    2
    .
    Because

    2

    2

    2
    .Therefore,

    2
    and
    since

    2
    ,

    2
    .
    Thus,givenarandomsample,oneshouldexpect:
    (5.7)

    s
    y
    2


    2
    ,
    and,fromEquation5.4,
    (5.8)

    y
    2
    1 ( )

    2
    .
    SubstitutingEquations5.7and5.8intoEquation5.6andcancelingproducesa
    formulafor

    R
    2

    thatisindependentofshocks:
    (5.9)

    R
    2

    5
    1


    _
    ,
    1

    +
    4
    1
    .
    The

    R
    2

    statisticisthusameasurablefunctionofstabilizationperformance,

    ,thatavoids
    biasfromthepossibledifferentialincidenceorseverityofshocksacross
    countries.Iftheintuitionabout

    R
    2

    expressedaboveiscorrect,thenthestatisticshouldberelativelyhighwith
    relativelyineffectivestabilization.Afirstderivativeconfirmsthis:
    (5.10)

    5
    1


    _
    ,
    1

    2
    > 0
    .
    As

    rises,representinglesseffectivestabilization,

    R
    2

    doesindeedrise,andas

    falls,sodoes

    R
    2
    .
    Examiningthe

    R
    2

    statisticthusmakesitpossibletotesttheimplicationofthemodelofChapter3,
    thatcountrieswithmoreindependentcentralbankshavelesseffective
    stabilizationpolicies.Theregressionequationalsoallowstestingoftheprincipal
    predictionofthemodel,thatcountrieswithrelativelylargeshocksshouldchoose
    toadoptrelativelydependentcentralbanks.Thestandarderroroftheregression
    isaproxyfortheincidenceandseverityofshocksintheeconomy.Thestandard
    erroroftheregressionisgiveninEquation5.5by

    ( )
    2

    5 ( )
    .Themodelpredictsthatacountrywithahigh


    shouldchoosearelativelydependentcentralbank.The


    statisticisanunbiasedestimatoroftherelativeextentofoutputshocks,butit
    maybeinefficient.First,thestandarderrormaybelowinacountrywith
    relativelyeffectiveconcurrentstabilization,forexampleduetostrongautomatic
    stabilizers.Thisproblemisparticularlyacutewithannualdata.Second,output
    shocksaredefinedhereasthecomponentofoutputthatcannotbeexplainedby
    ageneraltrendandbyoutputandthepricelevelintheprevioustwoperiods.
    ButeconomistsmakingpredictionsaboutGDPandinflationtrendsusefarmore
    complexmodels,andwithgoodreason.Variableslikemoneysupplygrowth,
    interestrates,andevenconstructionstartsarekeyingredientsinaneconomys
    dynamics.Evenifeconomistscouldpredict

    y
    t

    withcertaintyusingallavailableinformation,thelimitedinformationonwhich


    isbasedwouldensurethat

    > 0
    .Because


    isupwardbiasedforallcountries,andthereisnoapriorireasontosuspectthat
    thebiasshouldbegreaterincertaincountriesthaninothers,relativevaluesof


    areeffectivelyunbiased.Itisunclear,however,whethertheinefficiencyofthe


    estimatemakesitanimpracticalproxyoftheextentofshocks.Table5.2provides
    therelevant

    R
    2

    and


    forasampleofcountries.ThedataindicatethatSwedenhasthesmallestseverity
    ofshocks,buttheworststabilizationcontrollingforshocks.Denmarkhasthe
    beststabilization,andIcelandhasthemostsevereshocks.
    Table 5.2: The R-squared and Standard Error Statistics
    This table includes data that are proxies for the effectiveness of stabilization and the
    extent of shocks. The data are obtained, for each country, from statistics associated
    with the regression of Equation 5.2. The first datum for each country represents the
    R-squared statistic associated with the regression, and the second datum represents
    the standard error of the regression. Data are derived from International Monetary
    Fund (1993).
    Country RSQ SE Country RSQ SE
    Australia 0.276 2.02 Japan 0.512 2.43
    Austria 0.173 1.93 Luxembourg 0.262 3.06
    Belgium 0.354 1.93 Netherlands 0.287 2.40
    Canada 0.280 2.36 Norway 0.214 4.11
    Denmark 0.112 2.13 N. Zealand 0.182 2.60
    Finland 0.502 2.57 Portugal 0.240 3.46
    France 0.410 1.48 Spain 0.542 1.85
    Germany 0.212 2.12 Sweden 0.698 0.99
    Greece 0.678 2.13 Switzerland 0.348 2.18
    Iceland 0.276 4.33 United Kingdom 0.212 2.18
    Ireland 0.197 2.39 United States 0.323 2.09
    Italy 0.518 1.85
    ThechoiceofthedependentvariableinEquation5.1,

    y
    t
    ,asopposedto

    p
    t
    ,reflectsthispapersempiricalinterestinoutputratherthanpricestability.The
    modelofChapter3assumedthattherewerenosupplyshocks.Thisassumption
    madeitfeasibletodevelopatheoreticalmodelthatconsideredtheeffectsof
    demandshocksexclusivelyininflationterms.Inaworldwithjustdemand
    shocks,measurementofthe

    R
    2

    statisticfortheregressionofEquation5.2wouldbeequivalenttomeasurement
    ofthe

    R
    2

    statisticforanidenticalregressionwith

    p
    t

    asthedependentvariable.Theexistenceofsupplyshocks,however,impliesthat
    the

    R
    2

    statisticsforregressionswithdependentvariables

    y
    t

    and

    p
    t

    neednotbeequal.Moreover,becausesupplyshockschangethenaturallevelof
    output,the

    R
    2

    statisticsreflectdeviationsinthenaturallevelaswellasfluctuationsofoutput
    aroundit.
    Thecoincidenceofsupplyanddemandshocksthusmeansthatthereis
    considerablenoiseinthedatafromwhichthe

    R
    2

    statisticsinTable5.2aregenerated.Ideally,theresponsesofacentralbanktoa
    supplyshockandademandshockshouldbeseparatelyconsidered,andinthe
    contextofChapter3,onlyresponsestodemandshocksarerelevant.Bayoumi
    andEichengreen(1992),buildingonthetheoreticalfoundationofBlanchardand
    Quah(1989),illustratehowtheeffectsofdemandandsupplyshockscanbe
    separatelyassessed,givenfirstdifferenceddataonpricesandoutput.Blanchard
    andQuahdemonstratehowdemandandsupplyshockscanbeidentifiedgiven
    dataonoutputandunemployment.BayoumiandEichengreen,inadditionto
    extendingthisapproachtodataonpricesandoutput,provideafirststepin
    measuringdemandshockseverityandshockduration.Thekeytothe
    decompositionofpriceoutputdataintodemandandsupplyshocksliesinthe
    differentpermanenteffectsthattheseshockshaveonthelevelofoutputand
    prices.AsFigure4.2demonstrates,apositivesupplyshockhasapermanent,
    negativeeffectonthepricelevel,andapermanent,positiveeffectonthelevelof
    output.BecausetheaggregatesupplycurveontherightsideofFigure4.2will
    shiftinwardinthelongrun,ademandshockhasapermanent,positiveeffecton
    thepricelevel,andonlytemporaryoutputeffects.
    14
    Astheargumentwhich
    followsdemonstrates,andasBayoumiandEichengreennote,thesecriteria
    providemoreinformationthanisnecessarytoperformthedecomposition.
    Specifically,adecompositionrequiresonlyassumingthatsupplyshockshave
    permanenteffectsonthelevelofoutputwhiledemandshocksdonot.Bayoumi
    andEichengreencheckwhethershocksidentifiedwiththisassumptionare
    consistentwiththepredictedeffectofdemandandsupplyshocksontheprice
    level.Inthevastmajorityofcasestheyexamine,thetwoassumptionsareindeed
    consistent.
    15
    ThispaperadoptsBayoumiandEichengreensapproach,explained
    below.
    Theidentificationofdemandandsupplyshocksfromoutputandprice
    datarequiresatheoreticalfoundationthatallowsonetypeofdatatobe
    convertedintotheother.Let
    14
    Whilesupplyanddemandshocksbothhavepermanenteffectsonthepricelevel,theydonot
    necessarilyhavepermanenteffectsoninflation.
    15
    Of30datacases,BayoumiandEichengreenfindthatonlydecompositionsofNorway,Ireland,
    andtheRockyMountainregionoftheU.S.identifydemandandsupplyshocksinawaythatis
    inconsistentwiththepredicteddifferentialeffectsoftheseshocksonthepricelevel.

    and

    representafundamentaldemandshockandafundamentalsupplyshock,
    respectively,inperiod

    .Defineforperiod

    avector,

    ,offundamentaldemandandsupplyshocks,suchthat

    [ ]

    .
    16
    Similarly,define

    X
    t

    asavectorofoutputpricedataforperiod

    ,suchthat

    X
    t

    [ ]

    .Theassumptionthatonlysupplyanddemandshocksdeterminechangesinthe
    levelsofoutputandpricesallowsforavectorregressivedefinitionof

    X
    t
    ,as
    16
    TheTsuperscriptisusedfortypographicsimplicitytodenotethetransposeofamatrix.
    (5.11)

    X
    t

    0

    +
    1

    +
    2

    +
    ,
    where

    A
    k

    2 2
    areconstantparametersforintegers

    k 0
    .Ofcourse,because

    isnotdirectlyobservable,thisequationcannotbedirectlyestimated.However,

    X
    t

    mayalsoberepresentedas
    (5.12)

    X
    t

    0

    +
    1

    1
    +
    2

    2
    +. ..
    ,
    where

    C
    0
    , C
    1
    , C
    2
    , . ..
    2 2
    ,

    C
    0

    ,
    17
    and
    17

    hereisthetwobytwoidentitymatrix.Anidentitymatrixisamatrixwithdiagonalentries1
    andallotherentries0.
    (5.13)




    1
    ]
    1

    0

    .
    Defining

    A
    k

    0
    makesEquations5.11and5.12becomeidentical.The

    variableisdefinedasthevectorofshockstooutputandprices;thisdefinitionis
    consistentwiththatof

    X
    t

    asthevectoroffirstdifferencedoutputandpricesinperiod

    .Equation5.13thus
    relatesthevectorofoutputandpriceinnovationstothevectoroforiginal
    demandandsupplydisturbances.
    Thecomputationof

    thusrequiresanestimateof

    foreachtimeperiodandanidentificationofasingle

    A
    0

    tobeusedforalltimeperiods;


    0
    1

    .The

    vectormaybeestimateddirectlyforeachtimeperiodviaavectorautoregression
    of

    X
    t
    ,asfollows:
    (5.14)

    y
    t
    p
    t



    1
    ]
    1


    +


    1

    1



    1
    ]
    1
    +


    2

    2



    1
    ]
    1
    +




    1
    ]
    1
    ,
    wherethelastterm,equalto

    ,istheresidualoftheregression.Equation5.14isanautoregressive
    approximationoftheWoldmovingaveragerepresentationofEquation5.12.
    18

    TheestimationofEquation5.14requiresperformanceoftwoordinaryleast
    squaresregressions,oneidenticaltoEquation5.2andananalogousonewith

    p
    t

    servingasanestimateofthedependentvariable.The

    and

    parametersareanalogoustotherespectiveparametersofEquation5.2,but


    1
    ,


    2

    2 2

    tocapturetheresultofbothordinaryleastsquaresregressions.
    Because

    A
    0

    hasfourentries,fourrestrictionsshouldsufficetodefinethematrix.Bayoumi
    andEichengreendonotindicatetheformulaforthe

    A
    0

    theyuse,butnotethattheyderiveitbyadoptingthefirstthreeofBlanchardand
    Quahsrestrictions.Thenextseveralpagesofthispaperdefinetheserestrictions
    andderive
    18
    Woldsdecompositiontheoremstatesthatallstationaryautoregressiveprocesseshavemoving
    averagerepresentations.See,forexample,Judgeetal.(1985),p.231.

    A
    0

    fromthem.Thefirsttworestrictionsarethat
    (5.15)

    2
    1
    .
    Thisisanormalizationassumptionusedforidentificationpurposes.Aproblem
    withthisrestrictionisthatitmakesarbitraryanyattempttomeasure

    and

    themselvesviaEquation5.12.Thethirdrestrictionisthatdemandandsupply
    shocksareuncorrelatedrandomvariables,aconsequenceofwhichisthatthe
    covarianceof

    and

    is0.Thefourthrestrictionderivesfromtheassumptionthatdemandshocks,
    unlikesupplyshocks,haveonlytemporaryoutputeffects,becausetheydonot
    affectthelongrunaggregatesupplycurve.Thisimpliesthatthecumulative
    effectofdemandshockson...

    y
    t

    mustbezero.(BayoumiandEichengreen,p.15).
    Theserestrictionstranslateintotwoimportantmathematical
    consequences.Bothconsequencesrelyonthefollowingimplicationsofthe
    definitionof

    inEquation5.13:
    (5.16)




    1
    ]
    1

    0

    11

    12

    21

    22



    1
    ]
    1




    1
    ]
    1

    11

    +
    12

    21

    +
    22




    1
    ]
    1
    ,
    where

    a
    ij

    denotestheentryinthe

    throwand

    thcolumnof

    A
    0
    .Thenormalizationassumptionimplies

    ( )
    2

    ( )
    2
    1
    ,whiletheorthogonalityassumptionimplies

    0
    .
    TogetherwithEquation5.16,thisallowscomputationofthevariancesof

    and

    ,andthecovariancesofthesevariables:
    (5.17)

    2

    11

    +
    12

    ( )
    2

    11
    2
    +
    12
    2

    2

    21

    +
    22

    ( )
    2

    21
    2
    +
    22
    2

    ( )
    (
    11

    +
    12

    ,
    21

    +
    22

    )

    11

    +
    12

    ( )

    21

    +
    22

    ( )
    [ ]

    11

    21
    +
    12

    22

    '





    FromEquation5.17,thefirstconsequence,whichisnotedinBlanchardand
    Quah,follows,namelythat
    (5.18)

    A
    0
    A
    0
    T

    11

    12

    21

    22



    1
    ]
    1

    11

    21

    12

    22



    1
    ]
    1

    11
    2
    +
    12
    2

    11

    21
    +
    12

    22

    21

    11
    +
    22

    12

    21
    2
    +
    22
    2



    1
    ]
    1

    ,
    where

    isthevariancecovariancematrixof

    .Becauseanestimateof

    canbecalculated,Equation5.18effectivelyplacesthree
    restrictionson

    A
    0
    .Thesecondconsequencefollowsfromthefourthrestriction,thatthelongrun
    effectofthe

    parameteronthelevelofoutputmustbezero.AsBlanchardandQuahprove,
    since

    A
    k

    0
    ,itfollowsfromEquation5.16that
    (5.19)

    A
    k
    k0




    1
    ]
    1
    11

    0
    ( )
    0




    1
    ]
    1
    11
    0
    ,
    where

    M
    [ ]

    denotestheentryinthe

    throwand

    thcolumnofamatrix

    .Bymatrix
    multiplication,Equation5.19translatesintothefollowingrestrictionon

    A
    0
    :
    (5.20)

    C
    k
    k0




    1
    ]
    1
    11

    11
    +




    1
    ]
    1
    12

    21
    0
    .
    Thecomputationof

    C
    k
    k0

    ,where

    C
    k

    isanestimateof

    C
    k
    ,requiresthattheestimationofEquation5.14berelatedtotherepresentationof
    Equation5.12.Thismaybedoneasfollows:
    (5.21)

    X
    t

    1
    +

    2
    +

    +


    ( ) ( )
    1

    + +


    ( )
    +


    ( )
    2
    +


    ( )
    3
    +.. .
    ( )

    +


    0

    +


    1

    1
    +


    2

    2
    +...
    The

    parameterrepresentsthelagoperator,so,forexample,acoefficientof

    L
    2

    impliesthatthevariableofwhichitisacoefficientshouldbelaggedtwice.

    The
    secondlinecanbeproventobearestatementofthefirstusingthelagoperator.
    Thethirdlineisaninfiniteseriesexpansionofthesecond.Thecoefficientsinthe
    fourthlinearesimplyestimatesofthe

    parametersinEquation5.12.The

    C
    estimatesmaybecomputeddirectlyintermsof


    1

    and


    2

    byrecursivesubstitutionintothefirstlineofEquation5.21,sothat
    (5.22)

    C
    0
    ,

    C
    1
    ,

    C
    2
    ,

    C
    3
    , . ..
    { }
    ,


    1
    ,


    1
    2
    +


    2
    ,


    1
    3
    + 2


    1


    2
    , .. .
    { }
    ,
    where

    C
    k



    1


    1
    +


    2


    2
    .Oneapproachtocomputing

    C
    k
    k0


    isthustosumtheelementsofthissequence,untilitconvergestoanarbitrary
    levelofprecision.Convergenceofthissummationisguaranteedsincethe
    stationarityassumption,whichcanbeempiricallyverified,implies


    1
    ,
    2
    < 1
    .Analternative,andfaster,approachistouseEquation5.21todeviseaformula
    for

    C
    k
    k0

    .Specifically,theequalityofthesecond,third,andfourthlinesofEquation5.21
    impliesthatthesumofthecoefficientsinthefourthlineisequaltothecoefficient
    of

    inthesecondline.Itfollowsthat

    C
    k
    k0

    ( )
    1

    ,so

    C
    k
    k0


    1

    2
    ( )
    1
    .Let

    b
    ij

    denote


    1
    [ ]

    +
    2
    [ ]

    .Thismatrixinverse,andthustheestimatedsummation,canthenbecomputed
    asfollows:
    (5.23)

    C
    k
    k0


    1

    2
    ( )
    1

    1
    1
    11
    ( )
    1
    22
    ( )

    12

    21
    1
    22

    12

    21
    1
    11



    1
    ]
    1
    .
    Itisnowpossibletosolvefor

    A
    0
    .Tosimplifythealgebra,definetheparameter


    asfollows:
    (5.24)

    [ ]
    12

    [ ]
    11

    12

    22
    1
    .
    ThecombinationofEquations5.18,5.20and5.24thusconvenientlyreducesto
    thefollowingsetofnonlinearequations:
    (5.25)

    a
    11

    21

    21
    2
    +
    12
    2

    11

    21
    2
    +
    12

    22

    12

    21

    21
    2
    +
    22
    2

    22

    '



    where

    representstheentryinthe

    throwand

    thcolumnof

    .Asolutiontothissystem
    ofequationsidentifies

    A
    0
    :
    (5.26)

    A
    0

    11

    22

    12
    2

    11
    2
    12
    +
    2

    22
    t
    11

    2

    11

    22

    12
    2

    11
    2
    12
    +
    2

    22

    11

    22

    12
    2

    11
    2
    12
    +
    2

    22

    22

    11

    22

    12
    2

    11
    2
    12
    +
    2

    22





    1
    ]
    1
    1
    1
    Theambiguityofthesignof

    a
    12

    isintendednottoindicatethateithersignwilldo,butthatthesigndependson
    numericalcontext.Specifically,itcanbeshownthat
    (5.27)

    a
    12
    a
    22

    12

    21
    2
    .
    Thus,

    a
    12

    and

    a
    22

    mustbeofthesamesignif

    12

    21
    2
    > 0
    ,andofdifferentsignsotherwise.Thisthusprovidesenoughinformationto
    provideavalidspecificationof

    A
    0

    inEquation5.26.Itfollows,however,thatthisspecificationisnotunique.If

    12

    21
    2
    > 0
    ,then

    a
    12

    and

    a
    22

    mayeitherbothhavepositivesignsorbothhavenegativesigns;if

    12

    21
    2
    < 0
    ,either

    a
    12

    or

    a
    22

    butnotbothmusthaveanegativesign.Forsimilarreasons,addinganegative
    signtoboth

    a
    11

    and

    a
    21

    wouldprovideanadditionalvalidspecificationof

    A
    0
    .TheselectionoftheparticularconditionalspecificationinEquation5.26isan
    arbitrarychoiceamongfourpossibilities.
    Theidentificationofthe

    A
    0

    matrixinEquation5.26makesitpossibletodevelopindicatorsofthe
    effectivenessofstabilizationresponsestodemandshocks,andoftheseverityof
    theshocksthemselves.ThetechniquesofBayoumiandEichengreenarehelpful
    butnotcompletelysufficientforthispurpose.First,BayoumiandEichengreen
    donotdevelopanumericalproxyforstabilizationperformance.Instead,they
    graphthepathofoutputandthepriceleveltoaunitdemandshockas
    determinedbytheprocessofEquation5.11.Thepath,whichiscalledthe
    impulseresponse,isdeterminedbythe

    A
    j

    matrices,theimpulseresponsefunctions.Toderivetheimpulseresponse,
    assume

    and

    0
    ,andthattherearenofurthershocks,i.e.

    0
    where

    t > 0
    .Then

    [ ]


    0
    1 0
    [ ]


    11

    21
    [ ]

    .However,

    [ ]

    0 0
    [ ]

    for

    t > 0
    .Thus,fromthelastlineofEquation5.21,

    X
    t

    11

    21
    [ ]

    .Forsimplicity,the

    X
    t

    valuesaredefinedastheestimatedimpulseresponses.Let

    IRy
    t
    d

    denotetheimpulseresponseofthechangeinoutputinperiod

    toaunitdemand
    shockinperiod0.Thiscanbecomputedviamatrixmultiplicationas
    (5.28)

    IRy
    t
    d

    11

    11
    +
    12

    21
    ,
    where

    c
    ij
    k

    isashorthandfor

    C
    k
    [ ]

    andcanthusbeestimateddirectlyfromthesequenceforthe

    C
    parametersinEquation5.22.Thistechniquemakesitpossibletodeterminehow
    longittakesforaportionoftheinitialshocktooutputtodissipate,butdoesnot
    immediatelysuggestanumericalproxyforstabilizationperformance.
    Second,thenormalizationassumptionthat

    2
    1
    makesdirectmeasurementof

    and

    2
    ,i.e.oftheseverityofshocks,problematic.Thus,toallowformeasurementof
    thesevariables,analternativenormalizationoralternativeanalysisisrequired.
    BayoumiandEichengreensuggestthatalegitimatealternativenormalization
    leadsto

    A
    0
    A
    0
    T

    ,where

    isthecorrelationmatrixof

    and

    .For

    A
    0
    A
    0
    T

    tohold,however,

    a
    11
    a
    21
    +
    12

    22

    12
    mustbe
    true.However,maintainingtheorthogonalityassumption,Equation5.16implies
    (5.29)

    12

    ( )

    11

    21

    2
    +
    12

    22

    ,
    where


    isthecorrelationcoefficientfunction.Thus,BayoumiandEichengreens
    normalizationentails

    .Yetitwas
    preciselythearbitrarinessofanassumptionabout

    and

    thatmotivatedtheneedtofindanalternativenormalization.Inadditionto
    invalidatingaportionofBayoumiandEichengreensfindings,thisargument
    suggeststhatadifferentnormalizationisrequiredif

    and

    aretobeestimated.Thenormalizationmustdefine

    A
    0

    withoutmakingarbitraryassumptionsinvolving

    and

    2
    .Thisauthorwasunabletodevelopsuchanormalization,however.
    Bysolvingfor

    2
    ,itbecomespossiblefirst,tousethecalculationsoftheimpulseresponsesto
    deriveameasureofstabilizationperformance,andsecond,toderiveanindicator
    ofshockseveritythatisdirectlyanalogoustothestandarderrorstatisticsof
    Table5.2.Equation5.12implies
    (5.30)

    y
    t

    11

    +
    12

    ( )
    0

    .
    FromEquations5.16and5.30,
    (5.31)

    y
    t

    11

    11

    +
    12

    ( )
    +
    12

    21

    +
    22

    ( )
    [ ]
    0

    .
    Itfollowsthat
    (5.32)

    2

    11

    11
    +
    12

    21
    ( )
    2

    2
    +
    11

    12
    +
    12

    22
    ( )
    2

    2
    [ ]
    0

    .
    Itisnoweasytoderiveameasureofthevarianceinoutputthatboth
    controlsfortheseverityofdemandshocksindifferentcountriesandconsiders
    onlydemandshocks.Specifically,thatmeasureis

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    0

    .FromEquation5.28,itisclearthatthismeasureissimplythesumofthe
    impulseresponsevaluesacrosstimeperiods.Because

    C
    0

    ,thissummationcanbebrokenintotwocomponentsasfollows:
    (5.33)

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    0


    11
    2
    +
    11

    11
    +
    12

    21
    ( )
    2
    1

    .
    Thisdecompositionseparatesthevarianceofoutputattributabletodemand
    shocksintotwocomponents:thefirstisanindicatoroftheseverityofthe
    contemporaneousdemandshock,whilethesecond,expressedasaproportionof
    theleftsideofEquation5.33,indicatestheeconomicinstabilityinresponseto
    demandshocks.
    TheinterpretationofthefirstcomponentoftherightsideofEquation5.33
    reliesontheassumptionthatthereisnocontemporaneousstabilization.Given
    this,theimpulseresponsetoademandshockintheperiodtheshocktakesplace
    mustbeafunctionoftheshocksseverity.Thus,

    a
    11
    2

    isaproxyforshockseverity.Thismayseemcounterintuitive,becauseadirect
    measurementofshockseveritywouldproduceavaluefor

    2
    .However,thetotalvarianceofoutputinperiod0duetodemandshocksis

    a
    11
    2

    2
    ,andthisquantitycannotbedisaggregatedinto

    a
    11
    2

    and

    2
    .Effectively,theresultoftheassumption

    2
    1

    inidentifying

    A
    0

    isthatthe

    a
    11

    constantratherthan

    accountsforshockseverity.Similarlywithanidentificationbasedon

    a
    11
    1
    ,

    wouldaccountforshockseverity.Becausetheconsequenceofthe

    2
    1

    assumptionissimplyachangeinthevariablethatabsorbsthemeasurementof
    shockseverity,BayoumiandEichengreenssearchforanidentificationof

    A
    0

    thatmakesnoassumptionabout

    isunnecessary.
    Regardlessoftheseverityoftheshockandtheinitialimpulseresponse,if
    stabilizationpolicyisperfect,theimpulseresponseinsubsequenttimeperiodsis
    0.Thus,thelowerthesecondcomponentofthesummationinEquation5.33,i.e.

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    1

    ,themoreeffectiveistheresponsetodemandshocks.Animportant
    qualification,however,isthat

    a
    11
    ,theabsolutevalueofwhichisanindicatorofshockseverity,ispartofthe
    formulaforthissecondsummationcomponent.Thereisthusapossibilityof
    bias,althoughtheambiguityofthesignsoftherelevantparametersmakesit
    difficulttodeterminewhetherthebiaswouldconsistentlycauseoverestimation
    ratherthanunderestimationofstabilizationeffectivenesswhen

    a
    11
    2

    islarge.Intuitively,whentheimpulseresponseofoutputtoademandshockis
    largeinperiod0,itwillbelargeinsubsequentperiodstoo,evenifstabilizationis
    strong.Thecorrectionforthisistodivide

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    1


    by

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    0


    toachieveameasureofdemandshockstabilizationeffectiveness.Thismaneuver
    producesanindicatorthat,likethe

    R
    2

    statisticdevelopedearlier,measurestheproportionoftotaldemandshock
    causedoutputvariancethatisduetotheimperfectionsofdemandshock
    stabilizationpolicies.
    Anargumentthatthisistheappropriatemeasurecanbemadebyanalogy
    toEquation5.6,ignoringtheconstantparameterandconstanttermattributable
    todegreesoffreedomcomplications.Thisequationestablishesthatthe

    R
    2

    statisticistheproportionofthevarianceofoutputthatcanbeexplainedbythe
    economysdynamics.The

    y
    t
    2

    statisticand

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    1


    areanalogous,becauseeachcapturesthevariabilityinoutputtraceableto
    unmitigatedpastoutputshocksratherthannewfundamentalshocks.Similarly,
    the

    s
    y
    t
    2

    statisticand

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    0


    areanalogous,thesecondanindicatorofthefirstwhenonlydemandshocksare
    considered.Theratiodevelopedhereisthusavector,demandshockbased
    analogofthe

    R
    2

    statistic.The

    R
    2

    statisticwasinverselyrelatedtostabilizationeffectiveness,andbyanalogy,sois

    c
    11
    k
    a
    11
    +
    12

    21
    ( )
    2
    1

    11

    11
    +
    12

    21
    ( )
    2
    0

    .
    Afinaltrickcanfinesseaproblemthatthe

    R
    2

    statisticandthisrevisedmeasureshare.Bothstatisticsindicatetheeffectiveness
    ofstabilizationofoutputgrowth,ratherthanoftheoutputlevel.Equation5.32,
    inparticular,decomposesthevarianceinoutputgrowth,notthevariancein
    output.Therewasnowaytoevadethisprobleminderivingthe

    R
    2

    statistic,butimpulseresponsefunctionsprovideanescapehere.Theformulafor
    demandshockstabilizationeffectivenessdependsonsquaringeachperiodthe
    impulseresponseofthechangeinthelogarithmofoutputtoaunitdemand
    shock,andthencomputingtheproportionofthesumofthesquaresnot
    attributabletotheinitialimpulseresponse.Toensurethatthemeasurefor
    demandshockstabilizationfocusesonstabilizationoftheoutputlevelrather
    thanstabilizationofoutputgrowth,thesameprocedurecanbeappliedtothe
    impulseresponseofthelevelofoutputtoaunitdemandshock.Theimpulse
    responseinperiod

    ofthelevelofoutputisthesumoftheimpulseresponsesof
    thechangeinoutputforallperiodsupto

    ,i.e.,
    (5.34)

    IRY
    t
    d

    11

    11
    +
    12

    21
    ( )
    0

    ,
    Because

    IRY
    0
    d

    0

    ,theproxyfordemandshockincidence,denotedDSI,isstill

    a
    11
    2
    .FromEquation5.34andbyanalogy,theproxyforeffectivenessofdemand
    shockstabilization,denotedDSS,canbecalculatedasfollows:
    (5.35)

    DSS
    c
    11
    k
    a
    11
    + c
    12
    k
    a
    21 ( )
    k 0
    k




    1
    ]
    1
    2
    k 1

    c
    11
    k
    a
    11
    + c
    12
    k
    a
    21 ( )
    k 0
    k




    1
    ]
    1
    2
    k0

    Table5.3providestheDSSandDSIstatisticsforasampleofcountries.
    Table 5.3: Demand Shock Stabilization and Demand Shock
    Incidence
    This table includes data that are proxies for the effectiveness of demand shock
    stabilization and the incidence (severity) of demand shocks. Larger numbers
    indicate less effective stabilization for DSS and more severe shocks for DSI.
    Formulae for the derivation of these measures are discussed above. Data are
    derived from International Monetary Fund (1993).
    Country DSS DSI Country DSS DSI
    Australia 0.740 2.749 Japan 0.962 0.180
    Austria 0.655 0.575 Luxembourg 0.392 2.958
    Belgium 0.498 1.454 Netherlands 0.920 0.063
    Canada 0.569 0.515 Norway 0.856 2.814
    Denmark 0.920 2.704 N. Zealand 0.711 0.069
    Finland 0.969 0.377 Portugal 0.366 2.871
    France 0.923 1.520 Spain 0.926 2.271
    Germany 0.513 0.332 Sweden 0.378 0.971
    Greece 0.599 3.927 Switzerland 0.625 0.677
    Iceland 0.793 3.665 United Kingdom 0.822 4.050
    Ireland 0.844 0.015 United States 0.696 4.240
    Italy 0.556 3.296
    Chapter6:ResultsandConclusions
    Thischapterconsidersthecentralbankindependenceindicesdiscussedin
    Chapter4andthemeasuresofshockincidenceandstabilizationperformance
    thatChapter5develops.Themeasuresofshockincidenceareusedtoassessthe
    predictionofthemodelofChapter3,thatcountrieswithgreateconomic
    instabilityshouldhaverelativelydependentcentralbanks.Thedatadonotreject
    thenullhypothesis,thatshockincidencedoesnotaffectcountriesselectionofa
    levelofcentralbankindependence.Thestabilizationperformancemeasuresare
    usedtoassesstheimplicationofthehypothesisofthemodelofChapter3,that
    countrieswithindependentcentralbankshavelesseffectivestabilization
    performance.Thenullhypothesisforthistestisthatstabilizationperformance
    andcentralbankindependenceareuncorrelated.Thealternativehypothesesare
    thatcountrieswithindependentcentralbankshavelesseffectiveormore
    effectivestabilizationperformancethancountrieswithdependentcentralbanks.
    Althoughthefirstofthesetwoalternativehypothesesisconsistentwiththe
    modelofChapter3,thedataprovidesupportfortheoppositeconclusion.When
    largercountriesaregivenrelativelymoreweightthansmallerones,abroad
    rangeoftestsshowthatcountrieswithindependentcentralbanksstabilizethe
    outputlevelmostsuccessfully.
    Beforeexaminingtheresultsofthetest,itisusefultoconsiderthe
    consistencyofthevariousindicesofcentralbankindependence.Table6.1reports
    thecorrelationsbetweenthevariousindicesofindependence.Examinationof
    suchatableallowsassessmentofthearbitrarinessofindependenceindices.The
    tableindicatesthatthevariousindicesofindependencebasedpurelyon
    institutionalvariables,inthefirstsevenrowsandcolumns,arehighlycorrelated
    withoneanother.Insomecases,thismaybesimplybecauseoneindexisan
    extensionofanother.ButCukiermansCEWandCSWcorrelatewellwithother
    legalbasedindices,eventhoughhederivedhisdataindependently.Pollard
    (1993)notes,however,thatdiscrepanciesamongindicesmayreflectdifferent
    constitutionalinterpretationsaswellasdifferencesintheweightsassignedto
    componentsoflegalindependence;shecitesinparticulardiscrepanciesinthe
    legalbasedindicesforJapan.Similarly,Banaian(1994)complainsthat
    CukiermanincorrectlyassessestheextenttowhichtheFederalReservehas
    authorityoverpolicyissues.Evenslightinaccuraciesinindependenceindices
    maythwartattemptstofindtrendsamongdataalreadyfraughtwithnoise.A
    particularlynoticeablefeatureofTable6.1isthegenerallylowcorrelation
    betweentheCGTindexofgovernorturnoverandthelegalbasedindices.This
    couldindicatethattheturnoverrateofcentralbankgovernorsisapoorproxyof
    centralbankindependence.However,thenatureoftheCGTindexsuggeststhat
    itmeasurespoliticalnoteconomicindependence.Indeed,CGTiscorrelatedbya
    relativelyhigh0.54totheotherindexofexclusivelypoliticalindependence,
    GMTP.
    Table 6.1: Correlations of Independence Indices
    This table shows the correlations between various indicators of central bank
    independence. Each index is listed in both the first row and first column; the upper-
    right and lower-left of the table are symmetric. The computation of a correlation
    between two indices is dependent only on those countries for which both indices
    provide data.
    BP GMTP GMTE GMT AS CEW CSW CGT CQE CQS COI
    BP 1.00 0.52 0.63 0.71 0.92 0.68 0.65 0.03 0.64 0.58 0.68
    GMTP 0.52 1.00 0.40 0.83 0.74 0.67 0.65 0.54 0.86 0.86 0.67
    GMTE 0.63 0.40 1.00 0.85 0.72 0.48 0.37 0.16 0.20 0.22 0.80
    GMT 0.71 0.83 0.85 1.00 0.90 0.70 0.61 0.43 0.73 0.75 0.78
    AS 0.92 0.74 0.72 0.90 1.00 0.84 0.84 0.19 0.81 0.78 0.73
    CEW 0.68 0.67 0.48 0.70 0.84 1.00 0.98 0.20 0.62 0.69 0.33
    CSW 0.65 0.65 0.37 0.61 0.84 0.98 1.00 0.17 0.63 0.71 0.35
    CGT 0.03 0.54 0.16 0.43 0.19 0.20 0.17 1.00 0.37 0.35 0.43
    CQE 0.64 0.86 0.20 0.73 0.81 0.62 0.63 0.37 1.00 0.97 0.46
    CQS 0.58 0.86 0.22 0.75 0.78 0.69 0.71 0.35 0.97 1.00 0.51
    COI 0.68 0.67 0.80 0.78 0.73 0.33 0.35 0.43 0.46 0.51 1.00
    Itisalsousefultoexaminethecorrelationofthevariousindicatorsof
    stabilizationeffectiveness.Table6.2providesthesedata,andtheresultsarenot
    encouraging.Foreachindicator,alowernumberrepresentsbetterstabilization
    effectiveness,butsomeoftheindicatorsareinfactnegativelycorrelated.An
    optimisticexplanationforthelowcorrelationsisthatalltheindicatorsare
    reliable,butmeasuringqualitativelydifferentthings.Ifthisisthecase,thenthe
    morecomplexmeasuresshouldbegiventhemostattention,fortheybest
    addressrelevanttheoreticalissues.Maybe,forexample,theRSQandDSS
    indicatorsdonotexhibitcorrelationbecausemostoutputvolatilityisdueto
    supplyshocks.Or,perhapsRSQisaninadequateindicatorbecauseitmeasures
    thestabilizationofoutputgrowthratherthantheoutputlevel.Apessimistic
    explanationisthatsome(orall)ofthemeasuresarenotgoodindicatorsof
    stabilizationeffectivenessinallcountries.Thismightbetrue,forexample,if
    moststabilizationtakesplacewithinayear,ratherthanfromoneyeartothe
    next.Ifthatisthecase,testsusingmonthlyorquarterlydatamightresolvethe
    problem.
    Table 6.2: Correlations of Proxies for Stabilization
    Effectiveness
    This table shows the correlations between various indicators of stabilization policy
    effectiveness. The first row and column is the standard deviation of GDP growth; the
    other rows and columns reflect measures developed in Chapter 5. Each indicator is
    listed in both the first row and first column; the upper-right and lower-left of the
    table are symmetric.
    STDGDP SC RSQ DSS
    STDGDP 1.00 0.02 0.05 0.06
    SC 0.02 1.00 0.12 0.24
    RSQ 0.05 0.12 1.00 0.08
    DSS 0.06 0.24 0.08 1.00
    Thedatafromthestabilizationeffectivenessmeasuresareexpressedas
    pointestimates,notasconfidenceintervals.Theerrorislikelytobegreaterthe
    morecomplexthetest.Thereissomeevidencethattheremaybeproblemswith
    boththereliabilityandthevalidityoftheDSSmeasure.Onthereliabilityside,
    thedataissensitivetospecification;Todd(1990)notesthatthisisacommon
    problemwithvectorautoregressivemodels.Forexample,usingfourlagsrather
    thantwoproducesanindexthatishighlycorrelatedwiththeoriginal,buta
    handfulofcountriesaredeemedtohaveconsiderablybetterrelativestabilization
    whenfourlagsareused.Onewaytotestthevalidityofthemeasuresisto
    examinetheoveridentifyingpricerestrictions,thatis,tocheckwhetherthe
    impulseresponsefunctionssuggestthatdemandshockshaveapositiveimpact
    onthepricelevelandsupplyshocks,anegativeimpact.Only10of23countries
    metboththesecriteria.However,mostofthisnonconformitywasonthesupply
    side,as19of23countriesmetthedemandsidecriterion.Ameasureofdemand
    shockstabilizationmaystillbevalid,thoughitisdifficulttobesure.
    Theproxiesforshockseverity,SEandDSI,arecorrelatedtoeachotherby
    only0.24.Asbefore,however,itispossiblethatthissimplysuggeststhatmost
    seriousshocksaresupplyshocksratherthandemandshocks.Ifthisisso,then
    theemphasisondemandshocksinthemodelofChapter3maybeinappropriate.
    Inanycase,thedatadonotstronglysupportthehypothesizedrelationship
    betweenshockseverityandcentralbankindependence,asthedataofTable6.3
    indicate.Althoughthreeresultsarestatisticallysignificant,oneresultreachesan
    oppositeconclusionfromtheothertwo.Inaddition,noneoftheresultswas
    statisticallysignificantbothwithdataweightedbyacountrysGDPandwith
    unweighteddata.Giventhelargenumberoftestsbeingperformed,some
    spuriousresultsareinevitable,althoughofcoursethepositiveresultcouldbe
    genuineandtheothertwospurious,orthenegativeresultsgenuineandthe
    positiveresultspurious.Assumingthatthedataareadequate,thereasonable
    conclusiontodrawfromTable6.3isthatcountriessufferinggreatershocksdo
    notchoosemoredependentcentralbanks.Thereareatleasttwoplausible
    explanationsforthis.First,actualdifferencesinshockseverityacrosscountries
    maybeinsufficienttowarrantlargediscrepanciesinindependence.Thatis,ifthe
    constantsinChapter3wereknownforeachcountry,itmightturnoutthatthe
    optimaldegreeofindependencevariesonlyslightlyfromcountrytocountry.In
    thiscase,otherconcernsarelikelytodwarftheeconomicconcernsofChapter3
    inacountrysdeterminationofhowindependenttomakeitscentralbank.
    Second,theseverityofshocksatthetimecentralbankconstitutionswerewritten
    mightbeonlyweaklycorrelatedwithshockseveritymorerecently.Third,some
    orallcountriesmaynotconducttheanalysisofChapter3.Ofcourse,themodel
    doesnotdependonthedraftersworkingouttheconclusionofChapter3
    mathematically.Itmerelysupposesthatinacountrywithrelativelylargeshocks,
    thedraftersarerelativelymoreconcernedthatacentralbankwillbereluctantto
    mitigateshocks.However,itisplausiblethatthedraftersmighthaveother
    politicaloreconomicconcernsthatmakethemdisregardtheseconsiderations.
    Table 6.3: Tests of the Shock Incidence Hypothesis
    This table shows the results of tests of the hypothesis, predicted in Chapter 3, that
    countries with greater shocks are more likely to choose dependent central banks.
    The hypothesis was tested by regressing the various indicators of central bank
    independence against the two proxies for shock incidence. For each combination,
    two tests were performed, one giving equal weight to each country, and the other
    weighting the data for each country by that countrys GDP, so that, for example, the
    U.S. data is counted considerably more heavily than Luxembourgs. For each of
    these tests, the coefficient of the independent variable and the corresponding t-
    statistic are shown. There is a greater disparity in coefficients than t-statistics
    because different independence indices are defined across different ranges of
    numbers. An asterisk represents significance at the 0.05 level for a two-tailed test.
    Variables Unweighted Weighted by GDP
    Dep. Var. Ind. Var. Coeff. tstat Coeff. tstat.
    BP SE 0.05 0.13 0.75 1.15
    GMTP SE 0.89 0.83 1.26 0.70
    GMTE SE 1.22 1.09 0.90 0.53
    GMT SE 2.03 1.07 0.37 0.12
    AS SE 0.01 0.03 0.39 0.57
    CEW SE 0.03 0.58 0.05 0.41
    CSW SE 0.03 0.57 0.03 0.23
    CGT SE 0.03 2.42* 0.01 0.46
    CQE SE 0.01 0.06 0.17 0.86
    CQS SE 0.01 0.12 0.21 1.14
    COI SE 0.00 0.51 0.02 1.69
    BP DSI 0.15 0.90 0.04 0.38
    GMTP DSI 0.17 0.58 0.40 1.69
    GMTE DSI 0.34 1.12 0.20 0.84
    GMT DSI 0.48 0.93 0.61 1.43
    AS DSI 0.06 0.41 0.11 0.98
    CEW DSI 0.01 0.42 0.03 1.65
    CSW DSI 0.01 0.48 0.02 1.16
    CGT DSI 0.01 1.11 0.01 1.50
    CQE DSI 0.01 0.37 0.07 2.60*
    CQS DSI 0.02 0.45 0.07 2.44*
    COI DSI 0.00 0.50 0.00 0.36
    Thelackofsupportfortheshockincidencehypothesisdoesnotmake
    Chapter5sdevelopmentofmeasuresofstabilizationperformanceauseless
    exercise.ThevarianceofGNPgrowthisaflawedmeasureofstabilization
    effectiveness,evenifitisnotbiasedbydisparateshockincidence.Before
    examiningothermeasures,however,itispossibletoexamineAlesinaand
    Summers(1993)resultsmorefully.Theirfindingofnosignificantcorrelation
    betweenthevarianceofGNPandtheindependenceofcentralbanksis
    reproduciblewiththispapersGDPdata,butchangesofspecificationalterthis
    result.ThevarianceofGDPgrowthandtheASindependenceindexexhibitmild
    negativecorrelation,withastatisticallyinsignificantpstatisticof0.63.However,
    severaloftheindependenceindicesaremorecomprehensiveandmorecarefully
    definedthantheAlesinaSummersindex.Also,thestandarddeviationofGDP
    growthisabettermeasureofstabilizationthanthevariance,whichtendsto
    exaggeratedifferences.Regressionsofthestandarddeviationagainstthe
    independencemeasuresproducetwostatisticallysignificantresultsatthe0.05
    levelforatwotailedtest.TheresultscontradictthehypothesisofChapter3;
    moreindependentcentralbanksseemtohavebetterstabilizationeffectiveness.
    Thetwosignificantresults,whichcomefromthehighlycorrelatedGMTEand
    GMTindices,couldbeafluke.Achangeintheregressionspecification,however,
    providessomesupportingevidence.Specifically,theregressioncanbeweighted
    toreflectthesizeofdifferentcountrieseconomies.Whileregressionsinvolving
    theGMTEandGMTindicesnolongerproducestatisticallysignificantresults,the
    GMTP,CEW,CSW,andCGTindicesdoshowsignificantnegativerelationships
    withthestandarddeviationofGDPgrowth.InthecaseoftheCEWandCGT
    indices,thesignificanceholdsatthe0.01level.Itishardtoimaginethatthis
    couldbeacoincidence,particularlysinceCEWandCGTareindependently
    derived.Table6.4showstheresultsoftheunweightedandweightedregression
    testsinvolvingGDP.
    Table 6.4: Tests Using the Standard Deviation of GDP Growth
    This table shows the results of regressions checking for a relationship between the
    standard deviation of GDP growth and central bank independence. An asterisk
    represents significance at the 0.05 level for a two-tailed test. A double asterisk
    indicates significance at the 0.01 level.
    Variables Unweighted Weighted by GDP
    Dep. Var. Ind. Var. Coeff. tstat Coeff. tstat.
    STDGDP BP 0.00 0.01 0.05 0.37
    STDGDP GMTP 0.09 1.35 0.12 2.44*
    STDGDP GMTE 0.14 2.60* 0.07 1.20
    STDGDP GMT 0.08 2.31* 0.06 2.09
    STDGDP AS 0.07 0.47 0.11 0.79
    STDGDP CEW 0.97 0.98 1.41 2.95**
    STDGDP CSW 0.87 0.88 1.30 2.49*
    STDGDP CGT 3.41 1.01 6.43 3.07**
    STDGDP CQE 0.15 0.13 0.22 0.42
    STDGDP CQS 0.22 0.19 0.23 0.44
    STDGDP COI 16.12 1.65 0.12 0.02
    Resultsfromweightedregressions,ofcourse,arerelevantonlyifthe
    weightingisjustified.Weightingisappropriateiftheindependenceindicesor
    thestabilizationproxiesaresubjecttomoreerrorinsmallercountriesthanlarger
    ones;bothoftheseareplausible.First,stabilizationinasmall,openeconomy
    dependsgreatlyontheeffectivenessofstabilizationinneighboringcountries.
    Thiswouldbeparticularlytrueinasmallcountrythatfixesitsexchangeratetoa
    largerneighbor.Theconstitutionofacentralbankinsuchacountryhasless
    importancethanthepoliciesofthecountrytowhosecurrencytheexchangerate
    isfixed.Second,centralbanksmaybealessimportantfactortooverallstability
    insmallthaninlargecountries.Evenifasmallcountryandalargecountryhave
    shocksofequalseverity,thesmallcountrymayhavemoreidiosyncraticshocks
    becauseoflesserproductdiversification.Inhisclassiccontributiontothe
    optimalcurrencyarealiterature,Kenen(1969)showsthatsupplyshocksmaybe
    moredestabilizingincountrieswithrelativelylowproductdiversification.
    Smallercountriesmayalsomeasureeconomicaggregateslessreliablythanlarger
    countries.Theseconsiderationssuggestthatlargeeconomiesdatawouldhave
    lessnoisethansmallereconomies.Someevidencesupportingthishypothesis
    comesfromTable6.5,whichshowsthatthecorrelationbetweenthestabilization
    indicesimprovesoverTable6.2whencountriesareweightedbyGDP.The
    drawbacktoweightingcountriesbytheirgrossdomesticproductsisthatthe
    relationshipbetweenstabilizationeffectivenessandcentralbankindependence
    couldconceivablybedifferentinsmallandlargeeconomies.Thus,applicationof
    resultsfromaweightedregressiontothedesignofasmallcountryscentralbank
    mightberisky.Applicationoftheseresultstoasmalldevelopingcountrywould
    beparticularlyproblematic,becausethedynamicsofeconomicpolicymaking
    couldbeconsiderablydifferentindevelopingandindustrialeconomies.
    Table 6.5: Correlations of Proxies for Stabilization
    Effectiveness
    This table shows the correlations between various indicators of stabilization policy
    effectiveness, weighted by each countrys GDP. Each indicator is listed in both the
    first row and first column; the upper-right and lower-left of the table are symmetric.
    STDGDP SC RSQ DSS
    STDGDP 1.00 0.41 0.51 0.46
    SC 0.41 1.00 0.26 0.60
    RSQ 0.51 0.26 1.00 0.38
    DSS 0.46 0.60 0.38 1.00
    WhenweightedbyGDP,themeasuresofstabilizationeffectiveness
    developedinChapter5providepersuasiveverificationoftheresultsofTable6.4.
    Theunweightedregressionsdonotgenerallyshowstatisticalsignificance,with
    oneexception.ThereisasignificantnegativerelationshipbetweentheCGTindex
    ofgovernorturnoverandboththeSCandRSQmeasures.Thisisconsistentwith
    theresultsofTable6.4,incontradictiontothehypothesisofChapter3,butalone
    doesnotprovidesufficientproof.RegressionsweightedbyGDPprovidefar
    moreconvincingevidence,asTable6.6indicates.Of33totalweightedregression
    tests,theresultsof22arestatisticallysignificant.Ofthese22tests,11are
    significantonlytothe0.05level,6tothe0.01level,and5tothe0.001level.With
    theexceptionofthreeoftheunweightedregressions,everyregression,including
    thosethatarenotstatisticallysignificant,showsanegativerelationshipbetween
    theindependenceandstabilizationeffectivenessmeasures.
    Table 6.6: Tests of the Stabilization Effectiveness Hypothesis
    This table shows the results of tests of the hypothesis, argued for in Chapter 3, that
    countries with dependent central banks have less effective stabilization policies. The
    hypothesis was tested by regressing the various proxies for stabilization
    effectiveness developed in Chapter 5 against the various indicators of central bank
    independence of Chapter 4. For each of these tests, the coefficient of the
    independent variable and the corresponding t-statistic are shown. An asterisk
    represents significance at the 0.05 level for a two-tailed test. A double asterisk
    indicates significance at the 0.01 level. A triple asterisk corresponds to the 0.001
    level.
    Variables Unweighted Weighted by GDP
    Dep. Var. Ind. Var. Coeff. tstat Coeff. tstat.
    SC BP 0.00 0.02 0.01 0.29
    SC GMTP 0.02 0.98 0.04 3.47**
    SC GMTE 0.00 0.06 0.02 0.94
    SC GMT 0.01 0.60 0.02 2.34*
    SC AS 0.02 0.51 0.06 1.71
    SC CEW 0.05 0.32 0.34 2.44*
    SC CSW 0..05 0.38 0.32 2.21*
    SC CGT 0.98 2.25* 3.12 2.68*
    SC CQE 0.25 1.11 0.07 0.28
    SC CQS 0.24 1.10 0.03 0.10
    SC COI 1.94 1.87 4.76 2.99*
    RSQ BP 0.01 0.27 0.04 1.17
    RSQ GMTP 0.01 0.45 0.03 2.28*
    RSQ GMTE 0.03 1.77 0.04 3.12**
    RSQ GMT 0.01 1.20 0.02 3.29**
    RSQ AS 0.03 0.68 0.07 2.21*
    RSQ CEW 0.31 1.37 0.51 4.54***
    RSQ CSW 0.28 1.24 0.50 4.22***
    RSQ CGT 2.01 3.01** 1.93 3.55**
    RSQ CQE 0.07 0.19 0.21 0.75
    RSQ CQS 0.05 0.14 0.31 1.15
    RSQ COI 3.78 1.75 4.50 2.86*
    DSS BP 0.04 0.79 0.04 0.81
    DSS GMTP 0.01 0.28 0.06 4.09***
    DSS GMTE 0.00 0.07 0.02 0.89
    DSS GMT 0.00 0.12 0.03 2.61*
    DSS AS 0.05 0.79 0.09 1.84
    DSS CEW 0.34 1.31 0.61 3.87***
    DSS CSW 0.33 1.22 0.67 4.27***
    DSS CGT 0.27 0.28 2.67 3.76**
    DSS CQE 0.32 0.61 0.79 2.92*
    DSS CQS 0.04 0.09 0.72 2.35*
    DSS COI 0.96 0.43 6.33 3.31**
    TheresultsofTable6.4and6.6areparticularlypersuasivebecausethey
    holdformeasuresofstabilizationeffectivenessthatevenwhenweightedarenot
    veryhighlycorrelated.Thisimpliesthateachofthemeasurescapturesdifferent
    aspectsortypesofstabilization,asindeedthetheorybehindthesemeasures
    suggests,butthatwithrespecttoeachoftheseaspects,betterstabilizationis
    foundincountrieswithmoreindependentbanks.
    19
    Inaddition,themorerefined
    ofthemeasuresofTables6.4and6.6generallysuggestthenegativerelationship
    atahigherdegreeofstatisticalsignificance.Itissimilarlyreassuringthatthe
    significantrelationshipsholdbothforlegalbasedindicesofindependence,and
    fortheCGTindex,whichattemptstoprovideanobjectivemeasureof
    independence.Figure6.1providesagraphicaldemonstrationofhowdifferent,
    separatelyderivedmeasuresofcentralbankindependenceandstabilization
    effectivenesssupportthesameconclusion.
    19
    Oneimplicationofthisconsistencyisthatthetheoreticaldistinctionbetweenstabilizationof
    theGDPlevelandGDPgrowthmaybeirrelevantinpractice.Twoofthemeasurescapturethe
    stabilizationofGDPgrowth,andtwoofthemeasurescapturethestabilizationoftheGDPlevel.
    Also,ananalysisconductedusingaDSSmeasuretargetedatGDPgrowthstabilization
    producedqualitativelycomparable,thoughnotasstatisticallysignificant,results.
    Figure 6.1: Central Bank Independence and Stabilization
    Performance
    These graphs showcase two of Table 6.6s statistically significant results. The circle
    for each country is weighted to reflect that countrys GDP. The x-axes provide
    indicators of central bank independence, with higher values representing greater
    independence. The y-axes provide indicators of stabilization effectiveness, with
    higher values representing less effective stabilization. Although the graphs use
    different, separately derived indicators of both central bank independence and
    stabilization effectiveness, both demonstrate a negative relationship between
    independence and output instability.
    RSQ
    0
    0.1
    0.2
    0.3
    0.4
    0.5
    0.6
    0.7
    0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
    CEW
    Ala
    Aus
    Bel
    Can
    Den
    Fin
    Fra
    Ger
    Gre
    Ice
    Ire
    Ita
    Jap
    Lux
    Net
    Nor
    NZ
    Spa
    Swe
    Swi
    UK
    US
    DSS
    0.3
    0.4
    0.5
    0.6
    0.7
    0.8
    0.9
    1
    0.75 0.8 0.85 0.9 0.95 1
    CGT
    Bel
    Can
    Den
    Fin
    Fra
    Ger
    Gre
    Ice
    Ire
    Ita
    Jap
    Lux
    Net
    Nor
    NZ
    Spa
    Swe
    Swi
    UK
    US
    Theresultsthatarenotstatisticallysignificantarethosewhichareformed
    fromtheindependenceindicesmostvulnerabletocriticism.TheBPandAS
    indicesattempttoreflectthesamequalitiesastheCEWandCSWproxies,but
    theselattermeasuresaremorecarefullyderivedandcoverawiderrangeof
    countries.TheCQEandCQSindices,meanwhile,aredefinedforonly10ofthe
    23countries,andaresusceptibletoerrorsinquestionnaireresponses.However,
    therelativeinconsistencyoftheGrilliMasciandaroTabelliniindicesbelieseasy
    interpretation.TheGMTEindex,inparticular,producesastatisticallysignificant
    resultinonlyoneoffourcases.Thismaysuggestthattheeconomicaspectsof
    centralbankindependencearelessimportantthanthepoliticalaspects,atleast
    sofarasstabilizationisconcerned.Theonestatisticallysignificantresultwith
    thisindex,inadditiontothethreeothernegativecoefficientestimates,maybea
    vestigeofthehighcorrelationbetweentheGMTEandGMTPindices.
    Inconclusion,theevidencesuggests,first,thatacountrydoesnotchoose
    theindependenceofitscentralbankonthebasisofshockincidence,andsecond,
    thatacountrywitharelativelyindependentcentralbankhasrelativelyeffective
    stabilization.ThoughtheseresultscontradictthemodelofChapter3,thatmodel
    wasdevelopedundertheassumptionthat

    < 1
    ,i.e.,thatcentralbank
    interventionisatleastpartiallysuccessfulinmitigatingshocks.If,however,the
    draftersofcentralbankconstitutionsbelievethat

    1
    ordonothaveconsistent
    beliefsaboutthevalueof

    ,thenthelackofarelationshipbetween
    independenceandshockincidenceisexpected.Further,supposethatinfact,for
    allcountries,

    > 1
    .Itfollowsthatcountrieschoosingindependentcentralbanks,
    forwhateverreasons,shouldenjoythemosteffectivestabilizationpolicy.Sucha
    scenarioisthusconsistentwiththetheoreticalandempiricalresultsofthispaper.
    However,determinationofwhetherthisisthecorrectinterpretationofthedata,
    andassessmentofwhethercausalityunderliestherelationshipidentified
    betweencentralbankindependenceandstabilizationperformance,requires
    furtherresearch.
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