Abstract

Central bank independence and fixed exchange rates are alternative monetary commitment mechanisms that differ in terms of transparency. While central bank independence is an opaque commitment technology that is difficult to monitor, a commitment to an exchange rate peg is easily observed: either the peg is sustained or it collapses. Political systems also vary in terms of transparency. I argue that the transparency of the monetary commitment mechanism and the transparency of the political system are substitutes. In nations where the political process is transparent (democracies), central bank independence can effectively resolve the time inconsistency problem and produce low inflation because even obscure transgressions against the central bank are likely to be detected by interested agents and exploited by the political opposition. In nations where political decision-making is opaque and unconstrained (autocracies), governments must look to a commitment technology that is more transparent and constrained (fixed exchange rates) than the government itself. The transparency of the monetary commitment substitutes for the transparency of the political system to engender low inflation expectations. I test the "substitution" argument empirically and find that (1) central bank independence is effective in limiting inflation, but only in democracies, and (2) autocracies are much more likely to adopt fixed exchange rate regimes than democracies, controlling for other factors. 1 1.

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