The Political Economy of Inflation and Central Bank Independence

We study monetary policy-making in an economy with many sector-specific monopoly unions. It is assumed that the senior union members are in the majority and – due to the practice of lay-offs by inverse seniority – face a lower unemployment risk than the junior members. Consequently, the unions’ median voters are senior and set nominal wages that imply involuntary unemployment on part of the juniors. Thus, equilibrium unemployment is too high from a social welfare point of view. Nevertheless, an independent central bank is found not to produce an inflation bias because it is accountable to the majority of the population, which is not involuntarily unemployed. In contrast, government-dependence leads to an inflation bias and a higher variability of inflation, but has an ambiguous effect on employment variability. The reason is that democratic elections are about more than one policy issue, which is shown to give rise to political uncertainty about the monetary policy preferences of the elected government.