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The concept of central bank independence as a strategy for building credibility and maintaining stable economic policies. The lecture discusses the rational expectations phillips curve, society's iso-loss function, and the time-inconsistency problem. It also introduces the concept of an 'inflation nutter' deflationary bias and presents an optimal set of preferences for a central bank. The document concludes with a summary of the arguments for central bank independence and evidence from inflation rates and growth variability.
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Central Bank Independence and Conservative Central Banking
Independent CB
Society’s Iso-Loss function
2 2 2
[ ( ) ]
[ ( )]
e
e
e
π
π π π ε π
π π π ε
2 2 2
1
But the CB/government optimises
[ ( ) ]
[ ( )]
ε
ε π
π
π π π ε π
π π π ε
b
x
b
b bx
plug bx
L b x
L b x
e
e
e
=
= −
=
= + − + − = ∂
∂
= + − + −
1
1
1
21 2 2 0
2 2 21
But this is not credible
2
2 2 1
1
1
1
σ σ ε
π ε
=
′ = −
b
b
x
x
π A B
C
C 1
C 2
C 3
ε>
ε=
ε<
A’ B’^ C’
2 2 2
1
L x b ε x β
ε β
β β
Optimising with respect to β
( )
( ) 0 1
3
2 2 − =
= + ∂
∂ x b
L β β
σ β β
ε
Evidence - Inflation?
Central Bank Independence and average inflation rate 1971-95^ Chart 1
0
2
4
6
8
10
12
0 2 4 6 8 10
percent
Germany
Switzerland^ USA^
Japan Netherlands
Canada
Belgium
Denmark (^) France
UK
Italy
Growth Variability
Relative variability of growth 1971-95 and CB rank of Independence^ Chart 3
0
20
40
60
80
100
120
140
160
180
0 2 4 6 8 10
percent German
Switzerland
USA
Japan
Netherlands Canada
Belgium^ Denmark France
UK Italy
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