Central bank independence and fiscal conservatism

Author(s): McCaskie, Patrick W. (1998)

Created 22 Jul, 1998
Categories Working Papers
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An independent central bank is one of the possible solutions to the dynamic inconsistency problem inherent in monetary policy. A policy (announced in advance) is time inconsistent if the policy maker does not have appropriate incentives to implement it. In some cases the policy maker may want to announce in advance the policy to follow in order to influence the expectations of private decision-makers. However, after the private decision-makers have acted on the basis of his expectations, the policy maker may be tempted to renege on his announcements. This problem in the sphere of ‘monetarism’ has encouraged those who believe that stability of money values can be achieved best by lifting control of the money supply as far as possible out of the arena of politics. The reason for this is the vulnerability of governments to temptations to create money by monetizing excessive fiscal deficits and thereby engendering inflationary spirals rather than overt conservative fiscal measures. This paper argues that to guarantee central bank independence a high degree of fiscal conservatism is required. Section one after defining central bank independence and fiscal conservatism outlines the theoretical basis of central bank independence. Section two evaluates empirical studies relating to central bank independence and fiscal deficits. It musters support for the view that fiscal conservatism complements independence of central banks. Section three gives a brief comparative look at the Caribbean nexus. The conclusion gives a brief passive remark of the paper. It conceives of a few observations to govern future relations between fiscal and monetary policy.

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