Central Bank: Introduction

Two conjectures have become part of the conventional wisdom.

The first is that greater central bank conservatism (CBC, defined as a greater weight placed by the central bank on an inflation as opposed to an employment objective) reduces average inflation rates while leaving average real activity unaffected.1 In particular, greater CBC enables countries to overcome the inflation bias first stressed by Kydland and Prescott (1977) and Barro and Gordon (1983). Relevant work is also provided by Schaling (1995). Evidence for the effect of CBC on inflation is presented by Grilli, Masciandaro and Tabellini (1991), among others. Alesina and Summers (1993) provide some evidence that CBC has no impact on real activity; Hall and Franzese (1996) are less certain. The issue awaits more detailed statistical analysis.

The second bit of conventional wisdom is that economic performance is U-shaped in the degree of centralization of wage setting (CWS, defined as the number of independent units that participate in wage bargaining or wage setting). This notion is derived from the work of Bruno and Sachs (1985) and Calmfors and Driffill (1988), who argued that in highly decentralized labor markets unions have no monopoly power, while in highly centralized markets monopoly unions internalize the effects of their actions and hence moderate their wage claims; with an intermediate number of unions neither of these beneficial effects takes place, and economic performance is presumably at its worst. Both Bruno and Sachs (1985) and Calmfors and Driffill (1988) marshal some evidence but again, the issue is not fully settled empirically.

This paper offers a general equilibrium model, largely built up from microfoundations, in which neither of these tenets of conventional wisdom holds true. The key insights come from studying the effects of CBC and CWS jointly. Indeed, we find that once one takes into account the interaction between central bank conservatism and labor market centralization, many of the standard results concerning the effects on economic performance of CBC and CWS considered separately no longer hold.

CBC and CWS are seldom discussed together, although conceptually they naturally should be. The effects of CBC depend on the extent of an inflation bias under discretion, which in turn must depend (among other things) on the structure of the labor market and the distortions present there. Conversely, the effects of monopoly power in the labor market on nominal and real variables must necessarily depend on the rules governing monetary policy -in particular, how accommodating the central bank is. Empirically, this suggests that when trying to measure the effects of CBC one should control for the degree of CWS, and viceversa.