Monetary policy committee transparency: measurement, determinants, and economic effects

Get Complete Project Material File(s) Now! »

Contribution of the study

Despite central bank independence, transparency, and other policy reforms, the political influence on policy cannot be ruled out. The government’s inability to reform the structural distortions, for instance, may lead to severe budgetary constraints. In the long run, these distortions may restrict the government’s revenue choices and provide a rationale for inflationary finance. In this context, the first essay (“Taxing the unobservable: The impact of shadow economy on inflation and taxes”) focuses on one specific constraint that renders an otherwise on-target policy design off track __the size of the unofficial (or shadow) economy. The main question, in the context of public choice literature, is how the size of the shadow economy relates to the rate of inflation and tax revenue. A simple theoretical model with standard assumptions  about the macroeconomic structure predicts an increasing inflation and decreasing marginal tax revenue in the size of the shadow economy. The mechanism behind this result is simple: greater share of the shadow economy erodes the tax base. As a result, the marginal cost of raising a dollar of tax revenue increases, and the government, rationally, substitutes inflation tax revenue for income tax revenues. Consequently, a larger shadow economy results both in a higher inflation rate and a smaller share of taxes in the GDP. Some previous studies, notably Koreshkova (2006), also predicted a positive relation between inflation and shadow economy but there is no empirical evidence on it. We contribute empirical evidence based on observational data set covering a broad set of 150 countries. The empirical analysis is robust against econometric issues like endogeneity, simultaneity, alternative regressors, and different statistical measures of the same economic phenomena.
In Chapter 3 (“Transparency and output stability: International evidence”), we shift our focus from the factors that may render policy ineffective to those that may increase its effectiveness. Since the 1980s monetary policy has changed both in theory and in practice due to institutional reforms and new rules and practices (Acemoglu et al. 2008). One practice that stands itself out almost universally is that of transparency or the public availability of information related to policy procedures (Blinder, 2004). Theoretical expositions tell us that transparency improves agents’ learning and decision making by making the present and the likely future state of the economy more comprehensible. Regarding the economic effects of transparency, the theoretical and empirical literature focuses mostly on inflation and inflation volatility and do not consider its relation with output volatility. Perhaps this focus reflects intellectual ascendancy of inflation targeting as a monetary policy framework that assigns greater weight to stabilizing inflation8. Because optimal monetary policy can be used to stabilize either inflation or output but not both many studies on transparency predict that transparency about (dual) objectives of monetary policy or about shocks will cause an increase in output volatility. But pre-2007 worldwide stabilization does not fit well with these findings as it correlates with increasing transparency. To explain both the transparency (about the shocks) and observed output stability we develop a simple theoretical model in which central bank has a complete knowledge of macroeconomic disturbances. The model shows __ under the assumption that central bank’s preference for output stabilization is lower than firms’ preference for the same objective __ that transparency reduces output volatility. The assumption that central bank is less concerned with output stabilization than private sector is not unrealistic given the findings of Orphanides (2004) and Orphanides and Williams (2005) that Fed’s policy activism reduced significantly since 1980s. To further contribute to the issue, we gather a sample of 80 countries and provide empirical evidence on our theoretical prediction concerning negative link between output volatility and inflation. The empirical model draws on the Great Moderation literature to control for other influences on the output volatility. The empirical results are confirmed by various robustness procedures and causal effects are identified using instrumental variables in the framework of dynamic Arellano and Bond (1991) estimator.
The third essay (Chapter 4 “Monetary policy committee transparency: Measurement, determinants and effects”) continues investigating the effects of transparency and its role in macroeconomic stability. It develops new indicators for transparency focusing on the monetary policy committees. The main motivation behind this research is the empirical evidence that central bankers’ actions respond to their career incentives and sociological influences (Havrilesky and Gildea, 1992; Göhlman and Vaubel, 2007; Farvaque et al. 2009). Adolph (2005 and forthcoming) points out the possibility of moral hazard problem due to non-elected policymakers’ independence from public scrutiny. His work shows that central bank independence has increased the dependence of policy on subjective factors rather than decreasing it because policymakers favour policies that are in line with the interests of their (prospective) future employers. In this context, we construct an argument, using insights from organizational behaviour, sociology and psychology literature, that central banks must disclose information about their committee members as this information has economic and political value. To see the present practise in this regard, we construct an index using the information available on the official websites of central banks about their serving committee members. With this index, it is possible to see the impact of this information on the economic variables. Our empirical findings suggest a robust stabilizing influence of new monetary policy committee index (MPCTI) on the volatility of inflation. This finding also supports the general finding in the literature that policymakers’ sociological and educational backgrounds are important determinant of the inflation rate. It suggests that market participant awareness of this ‘determinant of inflation’ helps attain more stable rate of inflation.
To summarize the above discussion, Figure 1 provides a broad overview of the study linking the different aspects with each other.*

Research Approaches

The research presented in this thesis is primarily empirical although we always try to formalize our argument using related theoretical framework. Table 1 provides a summary of the research approaches used in each of the chapters.
The first column presents, respectively in each row, the measure of policy outcome being considered, the institutional aspect to which the study relates, the method of analysis that is used and the nature and time period of information. In columns 2, 3, and 4 we describe the research method use in each chapter to study the aspects mentioned in column 1. The row 1 of the column 2 tells us that it considers two policy variables namely, inflation and tax burden. For inflation, we use annual percentage change in the consumer price index as our main variable while for tax burden the work horse measure is tax revenue as a percentage of GDP. The row 2 of the column 2 indicates institutional focus of the Chapter 2. As shadow economy works as a constraint on the optimal policy design we take it as an institutional aspect. The size of the shadow economy, being observed only indirectly, is prone to mis-measurement. To avoid any bias in our results we take three different measures of the shadow economy. Our preferred measure is the Schneider et al. (2010) measure, which is based on DYMIMIC (dynamic multiple causes, multiple indicators)
methodology9. To see the validity of our analysis we use two alternative measures. One is the Johnson et al. (1998) measure that is based on electricity consumption method. The second is the structural model based estimates of the size of the shadow economy by Elgin and Oztunali (2012). Our conclusions are based on both theoretical argument and empirical evidence. The theoretical model develops a link between shadow economy and the policy variables. While empirical analysis__using linear, nonlinear, system, and instrumental variable techniques__ gather evidence. Our empirical results are robust and based on a large sample of more than 100 countries. Moreover, our sample has both time series and cross sectional variation which increases the information content.
9 That method infers the size of the shadow economy from variables such as direct and indirect taxation, custom duties, government regulations, the rate of unemployment, growth rate of real GDP, and currency circulation. In order to calibrate absolute figures of the size of the shadow economies from the relative DYMIMIC estimation results, they used previous estimates derived using the currency demand method.
Coming to Chapter 3, in column 3 row 1, we consider output volatility as the measure of policy outcome. Following previous literature, notably Blanchard and Simon (2001) and Cecchetti et al. (2006), we measure output volatility both as a moving standard deviation of year on year growth rate of output and as a log difference. The measured value of transparency is taken as an institutional aspect. Mostly, we use Eijffinger and Geraats (2006) multi-dimensional measure of transparency as updated by Siklos (2011). In robustness section we check our results replacing it by Crowe and Meade (2008) measure of transparency which is based on Fry et al. (2000) indicators. As row 3 of column 3 shows, we employ different econometric techniques to take care of issues related to causality, simultaneity, and interdependence among countries. Our analysis is broad based, comprising at least 80 countries, and covers a time period from 1997 to 2008. The results indicate __in an econometrically robust way__ a significant negative link between transparency and output stability.
In the fourth chapter (column 4 of Table 1) the focus is on inflation volatility which is measured as standard deviation of consumer price index over 1997 to 2007 period for each country. While inflation forecast volatility (the standard deviation of inflation forecasts taken from World Economic Outlook) for the same period is used as an additional proxy in the robustness section. The main variable of interest is the index that we have constructed about the backgrounds and sociological characteristics of the serving committee members of 75 central banks around the world. This index is based on information gathered from the official websites of the central banks accessed through the portal maintained by Bank of International Settlement (www.bis.org). The econometric analysis is used, first, to find the major determinants of transparency and then to see its economic effect. The analysis on determinants follows Hendry (2001) general-to-specific modeling approach which is less prone to specification errors. While for the economic effects of transparency we employ 2-step Generalized Method of Moments (GMM) instrumental variable regressions to circumvent reverse causality. The empirical analysis is multivariate cross-sectional and control for the influence of institutional transparency (as measured by Eijffinger and Geraat, 2006 index) and central bank independence, among other control variables.
Abstract: We test the notion that a government will rely less on taxes and more on inflation to finance its expenditures the larger the size of the shadow economy. In a sample of developed and developing countries over the 1999-2007 period, we indeed report a negative relation between the tax burden and the size of the shadow economy, and a positive relation between inflation and the size of the shadow economy. We provide evidence that they are conditional on central bank independence and the exchange rate regime. They survive a series of robustness checks, controlling for reverse causality, simultaneity, level of development, and estimates of the shadow economy.
Keywords: Shadow economy, Inflation, Taxes, Inflation tax, Instrumental Variable GMM Estimator, Panel data.
Estimates of the size of the shadow economy, or informal sector, routinely exceed 40 percent in developing economies (Schneider and Enste, 2000, Gërxhani, 2004, Schneider, 2005, 2007, La Porta and Shleifer, 2008). Those daunting figures imply that a large share of output can by definition simply not be taxed, because it remains undeclared and unrecorded. Such an erosion of the tax base is a major challenge to government finance. As a result, governments have to find alternative revenue sources to finance public expenditures. Inflation is one. Governments facing a large informal sector therefore face an incentive to shift revenue sources from taxes to inflation.
From a theoretical point of view, the notion that inflation can be used to tax the informal economy goes back at least to Canzoneri and Rogers (1991). Subsequently, Nicolini (1998), Cavalcanti and Villamil (2003), and Koreschkova (2006) applied the public finance motive of inflation put forward by Bailey (1956) and Phelps (1973) to suggest that using inflation to finance public expenditures may be optimal in the presence of a large informal sector. Végh (1989), Roubini and Sala-i-Martin (1995), and Blackburn and Powell (2011) put forward similar arguments in the case of imperfect tax collection. The common feature of those contributions is that they apply the optimal taxation principle, which implies that the marginal welfare cost of inflation and the marginal welfare cost of taxes should be equal. In the presence of positive public expenditures and of an informal sector, that policy rule implies a positive inflation rate. Furthermore, it implies that the inflation rate increases with the size of the shadow economy, while taxes decrease with it.
Surprisingly, those predictions have never been tested empirically. Admittedly, Nicolini (1998), Cavalcanti and Villamil (2003), and Koreschkova (2006) provide quantitative assessments of the relevance of the public finance argument. They calibrate their models, and provide estimates of the optimal levels of inflation and taxes implied by a given size of the informal sector. Koreschkova (2006) can even replicate the inflation gap between the US and Peru by focusing on the difference in the sizes of their shadow economies. However, quantitative estimates either rest on the comparison of two countries, like Koreschkova (2006), or are provided with no reference to real world examples, like Nicolini (1998) and Cavalcanti and Villamil (2003). Moreover, those estimates are purely normative. They describe what the relation between the size of the informal sector and the levels of inflation and taxes should be. They do not describe the actual relation between them. As there is no reason to a priori believe that governments maximize welfare, those estimates cannot be used to predict inflation and taxes, because actual policies are likely to depart from the optimum.
The present essay precisely aims at addressing this caveat by performing a systematic empirical test of the impact of the size of the informal sector on inflation and taxes in a large sample of countries, using several econometric techniques. We test the hypothesis that the shadow economy should tilt government finance from taxes to inflation on a panel data set of 162 countries for 9 years (1999-2007). We therefore provide quantitative estimates of the magnitude of the actual reaction of inflation and taxes to the size of the informal sector. We thus provide a positive analysis of the impact of the informal sector on inflation and taxes.
In line with our hypothesis, we observe strong evidence that the shadow economy has significant and robust effects on both inflation and taxes, even after controlling for major macroeconomic variables. More precisely, we find that inflation increases with the size of the shadow economy whereas taxes decrease with it.
Besides extending our understanding of the macroeconomic effects of the informal sector, those findings touch upon several more general strands of literature. Firstly, they complement our knowledge of the relation between taxation and the shadow economy. Theoretical and empirical research, such as Ihrig and Moe (2004) or Dabla-Norris et al. (2008), commonly assumes and documents that taxes drive firms out of the formal sector. The results of the present paper imply that the reverse effect exists. Secondly, the present essay contributes to our knowledge of the political economy of taxation and the tax burden, such as Acemoglu (2005) or Acemoglu et al. (forthcoming). Thirdly, the essay contributes to the empirical research on the structural determinants of inflation and seigniorage, such as Edwards and Tabellini (1991), Cukierman et al. (1992), or Aisen and Veiga (2008a, b). That literature has documented a robust relation between political instability and inflation. One explanation of the relation provided by Cukierman et al. (1992) is that political instability gives governments an incentive to delay the reforms that would improve the efficiency of the tax system. Huang and Wei (2006) also relate inflation to the efficiency of the tax system in a model of endogenous monetary policy with time inconsistency. However, neither Cukierman et al. (1992) nor Huang and Wei (2006) provide evidence of a relation between the efficiency of the tax system and inflation. By doing so, we document the key relation on which their models rest.
To reach those results, the rest of the essay is organized as follows. The next section formalizes the basic public finance argument relating inflation and taxes to the informal sector, using a simple but general model that emphasizes that the relation does not rest on the assumption of a welfare-maximizing government. Section 3 describes the data and the econometric strategy that we use. Section 4 provides the baseline results, and section 5 takes them to a series of robustness checks. Section 5 concludes.

READ  Enantioselective, potentiometric membrane electrodes

 A simple theoretical framework

To describe the impact of the shadow economy on the government budget, let’s consider a government that has to finance a given level of public spending G with two instruments, a flat tax on output with rate , and seigniorage.

Table of contents :

Chapter 1. Introduction
1. An overview of the political economy
2. Political economy of inflation
3. Contribution of the study
4. Research approaches
Chapter 2. Taxing the unobservable: The impact of the shadow economy on inflation and tax revenue
1. Introduction
2. A simple theoretical framework
3. Data and econometric methodology
4. Findings
5. Robustness checks
6. Concluding remarks
Appendix I. Tables
Appendix II. Variables definitions and sources
Chapter 3. Transparency and output volatility: International evidence
1. Introduction
2. Sources of output stabilization
3. A simple theoretical framework
4. Empirical methodology
5. Results
6. Robustness analysis
7. Conclusion
Appendix I. Tables
Appendix II. Variables definitions and sources
Chapter 4. Monetary policy committee transparency: measurement, determinants, and economic effects
1. Introduction
2. Aspects of transparency in monetary policy
3. Measuring monetary policy committee transparency
4. Theoretical determinants of MPCT
5. Empirical analyses of determinants of MPCT
6. The effect of monetary policy transparency on inflation variability
7. Conclusion
Appendix I. Tables
Appendix II. A) Constructing MPCTI
B) Variables definitions and sources
Chapter 5. Conclusion
1. Summary of conclusions
2. Perspective on future research

GET THE COMPLETE PROJECT

Related Posts