The ultimate determinants of central bank independence

14

stabilization, the balance between credibility and flexibility needs to be shifted towards
increased commitment to price stability.

Finally, we summarize the propositions from this section in Table 3.1.

Table 3.1. The ultimate determinants of central bank independence

In order to confront these propositions with some cross-country evidence, we can now
move on to the empirical evidence. This is the subject of the next section.

IV.EMPIRICAL EVIDENCE

In this section, the ultimate determinants of central bank independence discussed before
are empirically investigated. We will use, for that purpose, the latent variables method
(LISREL) to make a distinction between the optimal and actual (legal) degree of central
bank independence. The reasons for this distinction are two-fold. First, the propositions
derived in the former section are related to the optimal degree of central bank indepen-
dence and not to the actual (legal) degree. These propositions formulate the relationship
between the optimal degree and four economic and political factors in a country:
- the natural rate of unemployment (positive relation);

- society’s preferences for unemployment stabilization relative to inflation stabilization
(positive relation);

- the variance of productivity shocks (negative relation); and

- the slope of the Phillips curve (conditional positive relation).

These determinants, reflecting the economic and political structure of a country, explain
theoretically the optimal degree of central bank independence in that country.

Second, there is also an identification and measurement problem. Whereas the determi-
nants of central bank independence will change frequently during the sample period (i.e.
the period 1960-1993), the actual degree - approximated by the legal indices of central

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