The ultimate determinants of central bank independence

latent variables method (LISREL) in order to distinguish between actual and optimal
monetary regimes.

The paper is organized into four remaining sections, followed by three appendices. In
section II we present the theoretical model. Section III contains the derivation of the
optimal degree of central bank independence. In section IV we test the model with the
latent variables method. Our conclusions are given in Section V.

II.A SIMPLE MACROMODEL

The main purpose of this section is to combine the Alogoskoufis (1994) model of wage
and employment determination with the Rogoff (1985) model. We assume that there are
two types of agents, wage-setters (the union) and the central bank. Wage-setters unilate-
rally choose the nominal wage every period, and the central bank controls monetary
policy.

The sequence of events is as follows. In the first stage wage-setters sign each period
nominal wage contracts [Gray (1976), Fischer (1977a)]. Wage-setters know the domestic
monetary regime. They take this information into account in forming their expectations. In
the second stage stochastic shocks to productivity realize. These shocks are random and
cannot be observed at the time wage contracts are signed. In the third stage the central
bank observes the values of the shocks and — contingent on the chosen regime — reacts
to the shocks accordingly. In the fourth and final stage employment is determined by
competitive firms. This timing of events is summarized in Figure 2.1.

Figure 2.1. The sequence of events.

Stage 1 Stage 2 Stage 3 Stage 4

--1--1--1--1--

Nominal wage      Shocks      Central bank      Employment

contracts signed     realize       sets monetary      determined

policy

We now move to the supply side of the model.

II.1.Aggregate supply

Consider the following supply block. Capital will be assumed fixed, and output is given
by a short-run Cobb-Douglas production function

0<β<1

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