Central Bank Independence and Inflation: Schumpeterian Theory and Evidence

We first use a monetary Schumpeterian model to investigate how central bank independence (CBI) affects inflation. It is found that we can predict a mixed, non-monotonic relationship between CBI and inflation. Under inelastic labor supply, when the seigniorage is mainly used to finance entrepreneurs, a condition that is more likely in developed countries, CBI has a positive effect on inflation; in contrast, when the seigniorage is mainly used to finance non-productive government spending, a situation more commonly found in developing countries, CBI has a negative effect or no effect on inflation. As an empirical test, we build panel data for 68 countries during 1998–2010 and find that the effect of CBI on inflation is positive and significant in developed countries, and it is insignificant (at the 5% level) in developing countries in both system generalized method of moments (GMM) and instrumental variable (IV) estimations. Our results remain robust to the consideration of financial crises, financial development, and other factors affecting inflation. Our empirical findings provide support for our theory.