Asserting independence: Optimal monetary policy when the central bank and political authority disagree

Abstract

This paper solves for optimal monetary policy when households face uncertainty about whether the central bank is independent from the political authority. In our model an independent central bank maximizes its own preferences while a dependent central bank maximizes the preferences of the political authority. Households form beliefs regarding the likelihood that the central bank is independent and update these beliefs using Bayes” rule given the observed choice of interest rate. The central bank takes into account how its policy choice influences household beliefs. We find that the central bank suffers losses when it is perceived to be captured, leading the central bank to deviate from traditional optimal policy under rational expectations to demonstrate its independence to the households.