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Exchange Rate Regimes and Independent Central Banks: A Correlated Choice of Imperfectly Credible Institutions

Published online by Cambridge University Press:  19 July 2010

Cristina Bodea
Cristina Bodea
Affiliation:
Michigan State University, East Lansing. E-mail: [email protected]
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Abstract

Theory and empirical evidence show that low inflation is a precondition for economic growth. Independent central banks and fixed exchange rates are institutional mechanisms that help keep inflation low by lending monetary policy credibility to governments. However, the two institutions are commonly analyzed as substitutes that tie the hands of inflation prone governments. Thus, the literature has difficulties describing why governments would adopt both institutions and the interaction between them. This paper presents a model that allows policymakers the simultaneous choice of monetary institutions and shows that imperfectly credible institutions will overlap: when exchange rates are fixed but adjustable and central bank independence is not fully ascertainable, governments choose both institutions. More generally, the paper generates hypotheses about the conditions that make fixed exchange rates and independent central banks complements or substitutes, thus contributing to an explanation of the diversity of global monetary institutions in the post–Bretton Woods period.

Type
Research Article
Information
International Organization , Volume 64 , Issue 3 , July 2010 , pp. 411 - 442
Copyright
Copyright © The IO Foundation 2010

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