Monetary policies for developing countries: The role of institutional quality

Textbook discussions of monetary policies do not usually separate developing from developed countries. Are there important features about developing countries that might suggest that the optimal design of monetary policies should be different? In this paper, we study one particular feature that is prevalent in developing (and transition) economies, namely weak public governance. Obviously, developed countries are not immune to this problem, but it is far less prevalent than in many developing countries. Surprisingly, the consequence of this feature on the design of monetary policy has not been systematically examined. This paper aims to fill this void, and to demonstrate that the effect is not trivial. As many developing countries lack credibility in their monetary policy, a subject heavily studied in the literature, a conventional wisdom is that these countries should peg their currency to a major currency from alow-inflationary country, adopt a currency board, or dollarize. Our analysis in this paper, however, will show that when weak institutions are considered these policies are not necessarily appropriate. Our theory combines useful ingredients from two different strands of the literature. The first strand is on the design of monetary policy, which is too voluminous to be referenced completely here, but includes, as seminal and other important contributions, Kydlandand Prescott (1977) , Calvo (1978) , Barroand Gordon (1983) , Rogoff (1985) , Barro (1986) , Alesinaand Ta bellini (1987) , Cukierman (1992) , Svensson (1997) , Walsh (1995) , and Benignoand Wo odford (2003) .1 In this paper, we make use of a framework developed by Alesinaand Ta bellini (1987) , where the government'sobjective function includes provision of public goods in addition to minimizing inflation and output fluctuations. The second strand studies the causes and consequences of weak institutions, in particular, corruption. This literature includes work on the effects of institutions on development ( Rose-Ackerman, 1975; Shleiferand Vishny, 1993; Mauro, 1995 ). We i (2000, 2001) , Baiand We i (2000) , Fismanand We i (2004) and Duand We i (2004) investigated the consequences of corruption for international capital flows, tax evasion, and stock market volatility. As far as we know, these two strands of the literature have not been married before. In other words, none of the papers in the literature that we know of has examined the implications of weak institutions, including widespread corruption, for the design of monetary policies. For the purpose of our paper, we model weak institutions as an erosion of a government's ability to collect revenue through formal tax channels. This may arise through outright theft by tax officials or practices whereby tax inspectors collude with taxpayers to reduce the latter'stax obligation in exchange fora bribe. Under an inflation targeting framework, we study how the socially optimal level of the inflation target is affected by weak institutions. We further examine the implications for the design of several other monetary frameworks, includinga currency board, dollarization, anda Rogoff-type conservative central banker, and rank them in terms of social welfare. We also examine the authorities'incentive in strengthening institutions from apolitical economy perspective.download