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We consider a two-tier model of monetary policy where the central banker is both subject to the explicit influence of elected political principals through contracts and the implicit influence of interest groups willing to capture monetary policy. We analyze the impact of granting independence to the central banker on the scope for capture and the agency costs of delegating the monetary policy to a central banker. Political independence increases those agency costs but significantly stabilizes the politically induced fluctuations of inflation and improves ex ante social welfare.

Our current understanding of how the design of credible monetary institutions ensures greater economic stability has been significantly improved by the contracting approach pushed forward by Walsh (1995), Persson and Tabellini (1993) and Svensson (1995). This principal–agent literature argues that the inflationary bias due to the time inconsistency of monetary policy1 can be avoided by delegating through contract the implementation of this policy to a central banker (thereafter CB) who is separated from the main government body.2 This physical separation is often viewed as an ingredient of the CB's independence from the political sphere since it certainly insulates somewhat monetary policy from the day-to-day influence of political authorities and from fluctuations in the preferences of those political principals. However, the flip-side of this separation is that the CB may then be subject to various political pressures coming from organized interest groups willing to push their own views of what should be monetary policy.3 In this paper, we combine those two elements to obtain a more complete view of the political mechanisms which influence monetary policies. The CB is both subject to the explicit influence of elected political principals and to the implicit influence of interest groups which want to capture monetary policy. The choice of the CB legal status, i.e., whether he is independent or affiliated to the elected political principals, affects then the scope for capture of the monetary policy by private interests and different institutional choices lead to quite different policy outcomes. Under independence, the CB is less controlled by political principals and more responsive to interest groups. However, this status also isolates monetary policy from fluctuations in the identity of the elected political principals. As a result of this trade-off, the independence of the CB appears as an institutional best response to the threat of capture under political uncertainty. Our view of central banking as balancing political versus private interests influences on monetary policy is inherited from Friedman 1962 and Friedman 1972. According to him, central bank independence “embodies the very appealing idea that it is essential to prevent monetary policy from being a day-to-day plaything at the mercury of every whim of the current political authorities” but the flip-side of independence is that the CB becomes too much receptive to the “point of view of bankers”, an organized interest group attempting to influence monetary policy. Consequently, Friedman rejected CB independence arguing that if elected politicians cannot be trusted for the conduct of monetary policy, “money is too important to be left to central bankers”. The extreme solution suggested by Friedman was an inflexible monetary rule (a fixed growth rate of money) in order to “insulate monetary policy both from the arbitrary power of a small group of men not subject to control by the electorate and from the short-run pressures of partisan politics”. This policy has of course a very high social cost both in terms of stabilization and in terms of non-responsiveness to changes in the preferences of society. In this paper, we take a less rigid view of what should be monetary policy and investigate how contracts and institutions for monetary policy can be designed to trade-off the desire to insulate monetary policies from political authorities and the need to make those institutions robust to capture by private interests. To tackle these issues, we take a broad view of the control that a political principal exerts on the CB. These control rights involve not only the design of the CB's incentive scheme but also whether the CB can be removed or not after an election. When the CB is under political control, a newly elected political principal can choose a new CB affiliated to him. 4 Instead, under political independence, the CB cannot be fired by the elected political principal. 5 Contrary to the existing contracting literature, the CB's incentive contracts are not designed by social planners but by partisan political principals who want to please different constituencies and express thus different concerns for the trade-off between price control and surprise inflation depending on whether they represent a leftist or a rightist constituency. Because of informational asymmetry between the CB and the government, there is also scope for a collusion between private interest groups and the CB. 6 However, the scope for capture depends on the exact control rights that principals retain on the CB. In this framework, we ask whether granting political independence to the CB improves social welfare, whether more political independence makes monetary policy more sensitive to the influence of interest groups, and we finally investigate how those incentive contracts depend on the legal status of the CB. We show that the threat of capture on monetary policy increases the political fluctuations in monetary policy induced by the game of regime switching between rightist and leftist parties. Indeed, at the margin, left- and right-wing parties react differently to the threat of capture. The leftist party being more concerned by expansionary policies finds at the margin easier to fight capture by an anti-inflationist interest group. However, granting political independence to the CB somewhat insulates monetary policy from these political fluctuations: A stabilization effect. The cost of independence is nevertheless that the CB is more prone to capture by interest groups: A delegation effect. The stabilization effect is always strong enough to dominate the delegation effect. Hence, ex ante social welfare is greater under political independence than under political control. When capture of the monetary policy is a crucial concern, it is socially optimal to reduce the politically induced fluctuations of inflation it induces. This is better achieved by granting political independence to the CB who better stabilizes those fluctuations around a middle-road policy. Political independence is thus an optimal institutional response to the threat of capture in a world of political uncertainty. 7 The design of monetary institutions in a framework of regime switching between partisan political principals has already been addressed in models à la Rogoff (1985) where, instead of being corrected through an incentive scheme, the CB's preferences on the output–inflation trade-off can be chosen at the outset. The corresponding definition of independence is then related to the timing of the CB's appointment. A CB is independent when he is cooperatively appointed by the partisan parties before the elections. Along these lines, Waller (1989) and Alesina and Gatti (1995) show how politically induced fluctuations in output and growth can be stabilized under independence. In Alesina and Gatti (1995) for instance, political independence stabilizes inflation fluctuations because the private sector expectations are formed before any political uncertainty is resolved. By analyzing the difference in agency costs associated to the different legal status, we get a similar result without relying on the questionable assumption that private agents lock themselves into nominal contracts before the resolution of electoral uncertainty.8Waller (1992) studies how the timing of appointments and elections affects the CB's degree of inflation aversion.9 Paralleling this insight in a contracting framework, we relate also the timing of nominations to the exact control rights exerted by the political principals and we investigate also how this timing affects agency costs, contract design and institutional choices.10 Finally, our analysis borrows the methodology of Faure-Grimaud and Martimort (2000) who provide a theory of political independence for regulatory agencies but we apply this framework to a more complex macroeconomic environment. Section 2 presents the model. Section 3 analyzes the case of political independence. It stresses how the variance of inflation can be used as a tool to constrain collusive behavior between an anti-inflationist interest group and a CB. Section 4 shows how the nature of this collusion changes under political independence and how the legal status of the CB affects the monetary policies chosen by partisan governments. We demonstrate there that political independence reduces the fluctuations in the variance of inflation. Section 5 provides some welfare analysis and discusses the optimal institutional choice. Section 6 introduces pro-inflationist groups and shows the robustness of our results. Section 7 concludes and discusses possible extensions of our framework. Proofs are relegated to an appendix.

This paper has shown that different legal status of a CB are in fact associated with different opportunities for capture of the monetary policy by interest groups. The degree of political independence affects thus the agency costs paid to control the CB. An independent CB helps to stabilize the politically induced fluctuations of inflation but the agency costs of delegating monetary policy to such a CB increases also when the latter is granted political independence. Nevertheless, ex ante social welfare increases with political independence. This comes from the fact that the politically induced fluctuations due to agency costs are better stabilized by an independent CB. Several extensions of our framework could be discussed. First, it would be particularly interesting to analyze in our contracting framework how granting long-term tenures to CBs improves ex ante social welfare but may be costly when general economic conditions (like the distribution of shocks affecting the economy or the preferences of the agents) may change over time.39 Second, in our analysis, we have taken the probabilities that both parties get elected as purely exogenous. This has allowed us to explain the optimal choice of institutions for monetary policy in a world of political uncertainty. However, these probabilities could be endogenized and could thus depend on the monetary policies proposed by both parties before the elections. As we have seen, those political platforms are themselves significantly affected by the legal status of the CB. Such an extension of the model would also allow us to analyze the interesting feedback that institutions have on the electoral outcomes. The amount of political uncertainty and the institutional choice would thus be derived simultaneously. Finally, it should be stressed that our model could also be extended to the case where principals have no ability to commit to their incentive contracts. Our comparison between independence and political control would also be meaningful in this framework.