Monetary Policy
Agents of principle

Conventional economic wisdom holds that elected politicians misuse the power to create money in the face of electoral competition. In Discussion Paper No. 752, Michele Fratianni, Research Fellow Jürgen von Hagen and Christopher Waller assess whether giving central bankers similar powers also creates problems. They develop a principal-agent model in which the electorate makes decisions on the basis of observed economic performance but cannot directly observe current changes in the incumbent government's `competence'. Contracts fix nominal wages for a period, so the central bank can use surprise inflation to increase real output, but the public's welfare depends on price and output stability. The central banker derives a private gain from office, while the incumbent wants monetary surprises to improve its re-election chances. If the private sector forms its expectations rationally, there is an inefficient, positive `inflation bias', whose size depends on the degree of electoral uncertainty, whenever the central banker has an incentive to accommodate the incumbent's desires. Also, if the incumbent's re-election chances are strong (weak), the central bank will overstabilize (understabilize) shocks. Fratianni, von Hagen and Waller find that complete personal independence of the central banker from government or performance-orientated compensation packages can achieve optimal stabilization and eliminate the inflation bias, in contrast to Friedman-type policy rules or the appointment of `conservative' central bankers.

Their model suggests that electoral uncertainty is conducive to high inflation rates, which is consistent with the empirical observation that unstable political systems rely more heavily on seigniorage to finance expenditures. It can also account for the low level of long-run inflation in Japan, where the central bank is dependent on the elected government but the political system is extremely stable and the marginal benefit of using monetary surprises to secure re-election consequently very small.

Central Banking as a Political Principal-Agent Problem
Michele Fratianni, Jürgen von Hagen and Christopher Waller

Discussion Paper No. 752, January 1993 (IM)