The Political Economy of Monetary Institutions

Why do national governments choose the monetary institutions they do? While this question has long interested political economists, previous literature on the topic suffers from a central limitation: the choices of exchange-rate regime and central bank independence (CBI) have been analyzed in isolation from one another. This is surprising given that prominent arguments from this literature portray these institutions as solutions to the same problem—the time-inconsistency of monetary policy, or the inability of policymakers to commit credibly to staying the course on an announced policy. Time-inconsistency means that policymakers have an incentive to announce low inflation policies and then renege on that promise to achieve short-term improvements in real economic outcomes—growth and employment. Since private actors anticipate this behavior, attempts to create inflationary surprises will be frustrated, producing no additional growth and higher inflation. The best the policymaker can hope for is to make the promise of low inflation credible. CBI and fixed exchange rates have each been held out as ways of increasing the credibility of ex ante policy announcements and thereby reducing the inflationary bias of monetary policy. Both institutions insulate monetary policy from the direct control of those actors thought to have the greatest incentive to increase growth through ex post opportunism— incumbent politicians.