Imperfect institutions

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

                 Cristina Bodea

    Prepared for the IPES Inaugural Conference, Princeton 2006
                 What is the puzzle?
• In practice, independent central banks and fixed
  exchange rates coexist – Institutional Diversity

• The two institutions have specific disadvantages –
  they are not substitutes
  Leiderman & Svensson 1995, Canavan &Tommasi 1997,
  Keefer & Stasavage 2002, Edwards 1996, Broz 2002

• Models: the two institutions are alternative solutions
  to time inconsistent inflation preferences
  Rogoff 1985, Giavazzi & Pagano 1988, Milesi-Ferretti 1995
  Clark 2002 (exception)
                Previous formal work
• Traditional monetary policy model
  Kydland and Prescott 1977; Barro and Gordon 1983

• Institutions as solutions to time inconsistency
  Rogoff 1985, Giavazzi & Pagano 1988 Milesi-Feretti 1995, Lohman 1992

• Gives the government the choice of just one
 Cannot explain why institutions coexist
 Cannot address the interaction between
          What does this paper do?

• Give the government the choice of two

• Define more realistic institutions:
      • Fixed rates that the public knows can be devalued
      • Independent central banks whose independence is
        not entirely believed by the public
      • Costly devaluation of fixed rates
                    Main Results
• Imperfectly credible institutions explain why policy
  makers choose mixes

• Imperfectly credible institutions reduce inflation

• When the independence of the central bank is not
  believed, the right is more likely to make the bank
Standard Barro and Gordon setup

Li ( , y )   2  ai ( y  ky* )    k  1;      i  {L, R}

y  y*  (   e )   E ( )  0 V ( )   2

 w e
             Further assumptions
• One period game

• Fixed but adjustable exchange rates: Probability q
  that the announced fixed exchange rate regime
  collapses at the end of the period

• Status of central bank not clearly ascertainable:
  When the executive chooses and announces an
  independent bank, there is a chance p that the
  executive is not believed by the public
                Play of the game
• The government chooses the mix of institutions
• Workers set inflation expectations
• The executive observes the realization of the output
• Nature allows the fixed rate to collapse or maintain
• The executive sets inflation if the fix has collapsed
  and if it chooses flexible rates or a dependent
  central bank
• The central bank sets inflation to zero if granted
  independence; Inflation is zero if the fix survives
• Sequential game of complete information
• Backward induction
• Compute the ex ante loss function of the policy
  maker for each of the possible institutional solutions
  to the game
• Government chooses the institutional mix and the
  rate of inflation that minimizes its expected loss
  function, given inflation expectations
Imperfect institutions: The choice of an institutional mix

                                2  H 2
        Flex, CBI=0
                                                            2  H 2
                      Fix (q), CBI=0

                                       Fix (q), CBI=1(p)
     Imperfect institutions and costly devaluation: c  c*

                2                         2  H 2

                                                           2  H 2
                     Flex, CBI=0         Fix (q), CBI=0

                                                              2  H 2

                                   Fix (q), CBI=1(p)
     ai  1
cq         2
      ai                                                         H2

           ai  1        
     ai (1  q)
• Puzzle: “If the policy maker’s wrists were already
  bound by exchange target duct tape, what would
  be the effects of an additional pair of handcuffs
  from inflation targets an yet another loop of rope
  from central bank independence.” (Kuttner and
  Posen 2001)

• Imperfectly credible fixed rates and independent
  central bank - choose a mix

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