Non-complimentary Monetary Institutions

• In Event: International Monetary and Financial Governance

Abstract

A central puzzle in the political science research program on monetary institutions concerns the relationship between central bank independence (CBI) and fixed exchange rates (FIX) – that is, whether CBI and FIX serve more as “institutional substitutes (where the presence of one negates the need for another) or complements (where each reinforces the effect of the other)” (Bernhard, Broz, and Clark 2002, 694). Despite the importance of this question since it bears on both the selection and performance of these two monetary institutions, it has not yet been systematically answered. Using extended datasets on CBI and FIX with these monetary institutions measured on both a de jure and de facto basis with nearly global country/year coverage from 1970 to 2020, this paper considers whether these two monetary institutions have performed more as substitutes or as complements, first for inflation control and then for external currency stability. Using a consistent set of fixed effects specifications reducing the endogeneity problems associated with cross-national observational data, our results demonstrate that while CBI and FIX may function as substitutes especially for domestic price stability, they do not serve as complements for either domestic price stability or exchange rate stability. Indeed, the effectiveness of each monetary institution significantly declines in the presence of the other, an empirical finding that is not predicted by current theories and offering a new puzzle for this research program. This paper then advances an explanation for why CBI and FIX may often perform as non-complementary monetary institutions: they tend to be selected to achieve different macroeconomic objectives that are often in tension with each other. While our results show that CBI and FIX could perform as effective substitutes especially for inflation control, our data also show that these monetary institutions have not been generally selected as such in the post-Bretton Woods era. Thus, regarding the central question of whether CBI and FIX are complements or substitutes, we demonstrate that they neither function as complements nor are they selected as substitutes.

Authors

• David H. Bearce, Texas A&M

• Ana Carolina Garriga, University of Essex