Measuring the Independence of Central Banks and Its Effect on Policy Outcomes

TLDR

Central banks are often established as agencies with mandates to maintain price stability, allowing governments to calibrate the strength of their commitment to inflation control. This study constructs four distinct measures of central bank independence and investigates their association with inflation outcomes. The authors compile a legal independence index across 72 countries over four decades and develop three additional indicators—governor turnover rate, a specialist questionnaire index, and a composite of the legal index and turnover—to capture actual independence. Legal independence is inversely linked to inflation in industrialized nations but not in developing ones, where governor turnover better predicts inflation, and an inflation‑based independence index significantly explains cross‑country inflation variation.

Abstract

Making the central bank an agency with the mandate and reputation for maintaining price stability is a means by which a government can choose the strength of its commitment to price stability. This article develops four measures of central bank independence and explores their relation with inflation outcomes. An aggregate legal index is developed for four decades in 72 countries. Three indicators of actual independence are developed: the rate of turnover of central bank governors, an index based on a questionnaire answered by specialists in 23 countries, and an aggregation of the legal index and the rate of turnover. Legal independence is inversely related to inflation in industrial, but not in developing, countries. In developing countries the actual frequency of change of the chief executive officer of the bank is a better proxy for central bank independence. An inflation-based index of overall central bank independence contributes significantly to explaining cross-country variations in the rate of inflation.