ABSTRACT
The focus of this chapter is the theoretical literature on central bank (CB) independence. We provide a survey of the seminal contributions and of more recent research which reassesses the earlier work.1 Section 2 describes the ‘credibility problem’. An expectations augmented Phillips curve (or Lucas supply curve) is derived from a micro-foundations model of labour market and firms’ behaviour. Having clearly set out the source of an ‘inflationary bias’ in the conduct of monetary policy, Section 3 describes a second-best solution to the credibility problem first proposed by Rogoff (1985a). The solution is to delegate monetary policy to an independent central bank with an appointed board chosen to be ‘conservative’, in the sense that they assign a higher priority to low inflation than that of the representative government. This results in a trade-off between low inflation and effective monetary stabilization policy, and allows for both goal and instrument independence. The government now exercises influence by its choice of banker which could alternatively be interpreted as choosing a particular degree of CB independence.
