1. Exchange Rate Regimes and Independent Central Banks: A Correlated Choice of Imperfectly Credible Institutions Cristina Bodea Prepared for the IPES Inaugural Conference, Princeton 2006

2. What is the puzzle? In practice, independent central banks and fixed exchange rates coexist – Institutional Diversity The two institutions have specific disadvantages – they are not substitutes Leiderman & Svensson 1995, Canavan &Tommasi 1997, Keefer & Stasavage 2002, Edwards 1996, Broz 2002 Models: the two institutions are alternative solutions to time inconsistent inflation preferences Rogoff 1985, Giavazzi & Pagano 1988, Milesi-Ferretti 1995 Clark 2002 (exception)

3. Previous formal work Traditional monetary policy model Kydland and Prescott 1977; Barro and Gordon 1983 Institutions as solutions to time inconsistency Rogoff 1985, Giavazzi & Pagano 1988 Milesi-Feretti 1995, Lohman 1992 Gives the government the choice of just one institution Cannot explain why institutions coexist Cannot address the interaction between institutions

4. What does this paper do? Give the government the choice of two institutions Define more realistic institutions: Fixed rates that the public knows can be devalued Independent central banks whose independence is not entirely believed by the public Costly devaluation of fixed rates

5. Main Results Imperfectly credible institutions explain why policy makers choose mixes Imperfectly credible institutions reduce inflation expectations When the independence of the central bank is not believed, the right is more likely to make the bank independent

6. Model Standard Barro and Gordon setup

7. Further assumptions One period game Fixed but adjustable exchange rates: Probability q that the announced fixed exchange rate regime collapses at the end of the period Status of central bank not clearly ascertainable: When the executive chooses and announces an independent bank, there is a chance p that the executive is not believed by the public

8. Play of the game The government chooses the mix of institutions Workers set inflation expectations The executive observes the realization of the output shock Nature allows the fixed rate to collapse or maintain The executive sets inflation if the fix has collapsed and if it chooses flexible rates or a dependent central bank The central bank sets inflation to zero if granted independence; Inflation is zero if the fix survives

9. Solution Sequential game of complete information Backward induction Compute the ex ante loss function of the policy maker for each of the possible institutional solutions to the game Government chooses the institutional mix and the rate of inflation that minimizes its expected loss function, given inflation expectations

10. Imperfect institutions: The choice of an institutional mix

11. Imperfect institutions and costly devaluation:

12. Conclusion Puzzle: “If the policy maker’s wrists were already bound by exchange target duct tape, what would be the effects of an additional pair of handcuffs from inflation targets an yet another loop of rope from central bank independence.” (Kuttner and Posen 2001) Imperfectly credible fixed rates and independent central bank - choose a mix