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Central Bank Independence and Fiscal Policy: Can the Central Bank Restrain Deficit Spending?

  • Cristina Bodea and Masaaki Higashijima
Abstract

Independent central banks prefer balanced budgets due to the long-run connection between deficits and inflation, and can enforce their preference through interest rate increases and denial of credit to the government. This article argues that legal central bank independence (CBI) deters fiscal deficits predominantly in countries with rule of law and impartial contract enforcement, a free press and constraints on executive power. It further suggests that CBI may not affect fiscal deficits in a counter-cyclical fashion, but instead depending on the electoral calendar and government partisanship. The article also tests the novel hypotheses using new yearly data on legal CBI for seventy-eight countries from 1970 to 2007. The results show that CBI restrains deficits only in democracies, during non-election years and under left government tenures.

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Department of Political Science, Michigan State University (email bodeaana@msu.edu); European University Institute and Waseda University (email higashij@aoni.waseda.jp). An earlier version of this article was presented at the annual meetings of the Midwest Political Science Association and the European Political Science Association 2012, as well as at the Program on International Conflict and Cooperation seminar at Texas A&M University. We thank Raymond Hicks, Andrew Kerner and Robert Franzese for comments. Three anonymous reviewers and the editor also provided excellent suggestions. An online appendix with supplementary tables and replication data are available on the journal’s website. Data replication sets and online appendices are available at http://dx.doi.org/doi:10.1017/S0007123415000058

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