The ultimate determinants of central bank independence



16

The expected signs are denoted above the explanatory variables. The optimal degree of
central bank independence is assumed to be a
latent variable in our empirical model. Next
to the
observed explanatory variables measured in deviation from their mean (NAIRU_M,
WLEFT_M, VPROD_M and SLOPE_M), we need the actual (legal) degree of central
bank independence as an
observed variable. The actual degree of central bank indepen-
dence is approximated by the legal degree, according to the four main indices of central
bank independence in the literature.

The index of Alesina (AL) is a narrow measure of independence and based on Alesina
(1988, 1989). The total index of political and economic independence of Grilli, Mascian-
daro and Tabellini (GMT) is a broad measure based on Grilli, Masciandaro and Tabellini
(1991). The index of policy independence of Eijffinger and Schaling (ES) is, however, a
narrow measure based on Eijffinger and Schaling (1992, 1993a) and extended by Eijffin-
ger en Van Keulen (1994). The unweighted legal index of Cukierman (LVAU) is a very
broad measure of independence and derived from Cukierman (1992).11)

For our cross-country analysis, a set of nineteen industrial (OECD) countries is taken
which are ranked - with some exceptions - by the above-mentioned indices. The sample
period that we have chosen covers more than thirty years, namely the period 1960-1993
(for NAIRU: 1960-1988). The argument to choose such a long period is that it contains
many political and business cycles and, thus, comprises changes of the political and
economic structure affecting the optimal degree of central bank independence.

IV.2.The latent variables method

According to Bentler (1982), the essential characteristic of a latent variable is revealed by
the fact that the system of linear structural equations in which the latent variable appears
cannot be manipulated so as to express this variable as a function of
measured variables
only.12)

Aigner, Hsiao, Kapteyn and Wansbeek (1984) state that, since 1970, there has been a
resurgence of interest in econometrics in the topic of models involving latent variables.

11) As a consequence of the latent variables method (LISREL), these observed indices of central bank
independence are also measured in deviation from their means: AL_M, GMTT_M, ES_M and
LVAU_M. If all variables have an expected value zero, than their covariance equals E[x y].

12) For this definition of a latent variable, see: P.M. Bentler (1982), ‘Linear Systems with Multiple Levels
and Types of Latent Variables’, Chapter 5 in: K.G. Joreskog and H. Wold (eds.),
Systems Under Indirect
Observations: Causality, Structure, Prediction,
Part I, Amsterdam: North-Holland Publishing Company,
pp. 101-130. A clear overview of the latent variable method is given by: D.J. Aigner, C. Hsiao, A.
Kapteyn and T. Wansbeek (1984), ‘Latent Variable Models in Econometrics’, Chapter 23 in: Z. Griliches
and M.D. Intriligator (eds.),
Handbook of Econometrics, Vol. II, Amsterdam: Elsevier Science Publishers,
pp. 1321-1393.



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