Central bank independence and financial crises

In this paper we show that the degree of central bank independence (CBI) influences the optimal choice of monetary policy strategy during potentially unsustainable asset price booms. We assume that central bankers have to choose between a policy that preemptively raises short term real interest rates in the boom phase to prevent the build-up of a financial market crisis scenario and the cleaning-up strategy that ignores its impact on the likelihood of a future crisis. We find that the more independent central bankers are, the more likely it is that they will refrain from implementing a pre-emptive monetary tightening to maintain financial stability. Hence, our model results stand in sharp contrast to the view that CBI fosters financial stability. The intuition underlying our result is that a pre-emptive interest rate hike among other things gives rise to a lower inflation rate in the boom period. Whether this disinflation gives rise to additional costs or benefits depends on the degree of CBI. It can be beneficial for dependent central bankers who otherwise would suffer from a higher inflation bias. However, for independent central bankers this disinflation leads to an undesirable undershooting of their inflation target.