Central Bank Independence and Output-Inflation Trade-off in the European Union

Abstract

Central bank independence continues to become the global standard for the activities of monetary authorities. Increasing the independence of the central bank is widely acknowledged to decrease inflation by enhancing the credibility of commitments to price stability. This does not create an effect on economic costs in real terms, such as economic growth or employment.In accordance with Article 105 (1) of the Treaty on European Union, the primary objective of the ESCB shall be to maintain price stability. The statutory mandate to aim at price stability will give the ESCB a clear direction for its policy. This idea is rapidly becoming the consensus of academics and policymakers not only in the EU countries, but also all over the world.
This paper examines the empirical relationship between central bank independence and the costs of disinflation among the EU countries. Many previous papers suggest that central bank independence has a negative correlation with inflation. Granting greater independence to a central bank associates with lower inflation. However, few papers elucidate the relationship between central bank independence and the costs of disinflation. To investigate the effect of central bank independence on the trade-off parameter, we create estimates for both the EU and the G7. We use various ‘political’ and ‘economic’ indices provided by several papers to gauge central bank independence.
The result shows there is a positive correlation between central bank independence and the trade-off parameter in the EU. There are, of course, many other factors that determine output-inflation trade-off or the slope of the Phillips curve, but the clear real cost of disinflation is shown. For the EU countries at least, the growing political independence of central banks may have substantial real effects than in other countries such as those in the G7.
However, the evidence of the negative correlation between central bank independence and average rates of inflation shows that the important issue of causality is a negligible factor. There may be a labor market structure that makes reducing inflation more costly. Such factors may increase the value of an independent central bank that maintains low inflation. For example, there may be nominal wage rigidity in the EU.
Our empirical evidence suggests that both the incentive to inflate and the costs of reducing inflation may increase with greater central bank independence. Central bank independence delivers lower inflation but with real effects. It is certain that individual countries will have more independent central banks in the near future. Therefore, the problem of disinflation may be a big cost for the EU. The EU unemployment rate is quite high now. That may create many problems for achieving independent central banks.