Central Bank Independence and Budget Deficits in Developing Countries: New Evidence from Panel Data Analysis

Over the past two decades, many countries have passed legislation giving more independence to their central banks. This institutional evolution has concerned several developed countries but also developing countries and, is consistent with the Barro and Gordon's theory of time-inconsistent monetary policy, which emphasizes the importance of independence in terms of acquiring anti-inflationary credibility. But, central bank independence (CBI) could also affect the design of fiscal policy. Indeed, theoretical literature shows that a greater degree of independence influences government to fiscal discipline; conversely, a weak degree of independence may influence the government to pursue lax fiscal policy. However, the few empirical studies that attempted to assess the relation between CBI and budget deficits principally focused on industrial countries and provided disappointing econometric results. This paper seeks to address this gap in the literature by providing empirical analysis of the influence of CBI on budget deficits in a large set of developing countries over the 1995-2004 period. Using a panel data analysis and two indicators of CBI, the results show a negative relationship between CBI and budget deficits.