Central Bank Independence and its Impact on Fiscal Policy Behaviour

Abstract

This paper investigates the impact of central bank independence on fiscal policy behaviour, with a focus on political budget cycles and countercyclical fiscal policy. Multiple Fixed Effects models are estimated using panel data from 72 countries. Analyses are conducted for both de jure (legal) central bank independence and de facto (effective) independence. For some estimations, marginal effects plots using categorical analyses are included. The analysis shows a stronger positive effect of de facto independence on the fiscal balance, but neither de facto nor de jure central bank independence reduce political budget cycles. Both measures promote countercyclicality. Higher levels of rule of law increase the countercyclical effect of de jure independence, especially when de jure independence is low. Both de facto and de jure central bank independence deter fiscal deficits, but this effect is stronger and more significant for de facto independence and more present outside of the election cycle. Concluding, central bank independence has a positive impact on the fiscal balance, but not always in the way that is expected.