The Political Economy of Inflation, Labour Market Distortions, and Central Bank Independence

Using the citizen–candidate model we study the government’s choice of institutions for the labour market and the central bank and derive the implications for inflation and employment. We derive conditions for the existence of equilibria in which the labour market is distorted and the central bank is dependent or independent under a range of conditions affecting central bank dependence, the post–election cycle in inflation and employment and inflation bias. Our results imply that average inflation and inflation variability are lower under an independent central bank whereas employment variability can be lower or higher, consistent with evidence for OECD countries