Central bank independence and macroeconomic performance: A simultaneous equations approach

This paper examines the relationship between central bank independence (CBI) and macroeconomic performance using simultaneous equation modeling. With the ratio of central bank claims on the government to GDP as the de facto inflation, exchange rate depreciation and output, and analyze whether this effect varies across different levels of economic development. The model is composed of three equations: inflation rate, nominal exchange rate depreciation and output, and is estimated for a sample of 37 countries for 1975 to 2005 using the Two Stage Least Squares technique. We find that in general, CBI reduces inflation without increasing depreciation or decreasing output, thus validating the free lunch hypothesis. However, this result is not robust when the remaining outliers are removed from the sample. Moreover, we find that the free lunch hypothesis holds true only for developed countries. In developing countries on the other hand, the inflation reducing effect id lower, and higher CBI is now associated with higher output. In all regressions, there is no evidence of a statistically relationship between depreciation and CBI