Central Bank Independence in Transition Economies

W. Maliszewski 

CASE Foundation 

10

be credible. If the zero inflation commitment is not binding, people realise that 

policymakers can fool them by selecting higher inflation once the expectations have 

been set. Because expected loss from “cheating” is lower than from sticking to the 

rule, policymakers have always incentive to do so. Accordingly, people expect 

positive inflation rate. If policymakers select zero inflation in this case, the outcome is 

even worse than the discretionary equilibrium because the actual inflation rate is lower 

than expected and the rate of unemployment is higher than natural. Thus policymakers 

are forced to choose positive inflation rate.  

The model is based on the employment motive for monetary expansion 

(policymakers care about inflation and employment in the loss function) but it can be 

easily extended to any other “temptation” described in sections 1.2-1.4. If the revenue 

motive is considered (Barro 1983), the value of the policymakers' loss function 

increases with the actual and expected inflation and decreases with the amount of 

seignorage. In this case, it is minimised subject to the function linking seignorage 

revenues with the money growth and inflationary expectations. If the Government 

values these revenue much more than the benefits from the low inflation, the rate of 

monetary expansion (and inflation) will be excessive. The seignorage revenue will be 

lower than could be if the money growth was decreased. This result is similar to the 

inflationary bias in case of the employment motive. Policymakers are not able to 

commit themselves to the optimal monetary expansion and have to inflate more than 

desired to achieve the policy goals. 

Similar mechanism leads to the inflationary bias when the balance of payment 

motive is considered (Cukierman 1992). In this case the first element in the loss 

function is a (squared) deviation of the balance of payment from the desired level and 

the second element is a (squared) rate of inflation. It is assumed that the purchasing 

power parity holds and that the price level is solely determined by the nominal 

exchange rate. The model is slightly more complicated than previous ones since 

income effects of the devaluation are taken into account (namely the increase in 

income and change in value of government debt hold by private agents). However, the 

main conclusions are similar. If the government cannot precommit itself to the fixed 

exchange rate, people expect devaluation and the inflationary bias arises. 

All results show the time inconsistency problem in the monetary policy. In the 

absence of credible precommitments, rule-based policy is optimal but time-

inconsistent while discretionary policy is time-consistent but suboptimal. The 

monetary policy is subject to inflationary bias.