Corruption, Central Bank Independence and Optimal Monetary Policy in a Simple Model

This paper attempts to examine the issue of central Bank Independence (CBI) and corruption in explaining how each variable may shape the implementation of optimal monetary policy. This is not without precedent - there has been some empirical work on this relationship - particularly in assessing the determinants of CBI (see Farvaque, 2002, Damato et al (2007) and references cited within) and on the relationship between different manifestations of CBI (see Ahsan et al, 2006 and Crowe and Meade, 2008). Using this empirical work as motivation, we intend to present some simple analytics using a small open economy macroeconomic model. We wish to combine and extend the recent work by Huang and Wei (2006) and Wu (2008) on the effect of corruption on monetary policy choice with the work by Ismihan and Ozkan (2004), Eijffinger and Hoerberichts (2008) and Krause and Mendez (2008) on the effect of CBI on monetary policy choice. In contrast to the analytical work to date on these issues, we present monetary policies in the form of an optimal monetary policy rule (MPR) where the instrument of policy is the real interest rate (see Ball, 1999 and Cavoli, 2008). This allows us to examine how the policy instrument reacts to key economic information - including the extent of CBI and the existence of corruption. As with other contributions to this literature, the particular monetary policy regime will be determined by a central bank loss function. We focus our attention on a strict inflation targeting regime, flexible inflation targeting and a (real) exchange rate targeting regime. Rather than focusing on the outcomes of monetary policy (particularly inflation) as with many papers in this literature, we will focus on how the central bank's instrument of policy moves in reaction to the key variables relating to CBI and corruption.download