Central bank independence, financial market development and inflation

Abstract

Central bank independence (CBI) and inflation relation has long been a debate and is established in many studies, such as Bade and Parkin (1982), Alesina (1988, 1989), Grilli, Masciandaro, and Tabellini (1991), and Cukierman, Webb and Neyaptı (1992). Although these studies address the negative relation between CBI and inflation, they do not consider the effect of the development level of financial markets on this relation. Posen (1995) considers the effect of financial market development by using effective financial opposition to inflation formed by the inflation-averse groups. He tests the effect of this variable on CBI and inflation simultaneously. He claims that the variable, which decreases inflation is effective financial opposition to inflation (when used with CBI) rather than CBI. Thus, he states that rather than analyzing the direct relation between inflation and CBI, the effect of effective financial opposition to inflation on CBI and inflation should be investigated. Based on this study, this thesis looks at the effect of financial market development (FMD) both on CBI and on the relation between CBI and inflation by using alternative indicators for FMD. We find that there is a significant and positive relation between CBI and FMD for non-transition countries. Moreover, although Posen (1995) states that CBI does not have a significant effect on inflation when EFOI is included as an additional explanatory variable, we find evidence that both FMD and CBI have a significant effect on inflation. However, the results of the estimations are not robust to changes in samples.