Public investment, inflation persistence and central bank independence

Abstract

Purpose

The purpose of this paper is to investigate, both theoretically and empirically, the institutional setting of monetary policy making that mitigates the effects of productive public investment on inflation persistence.

Design/methodology/approach

In the theoretical approach, the authors consider a simple monetary game model à la Barro-Gordon introducing, apart from stochastic output shocks, indexed wage contracts and public investment effects. Then, the authors empirically produce inflation persistence and public investment persistence by estimating a first-order autoregressive model in a fixed rolling window of 36 months for the UK and also use a dummy in order to incorporate the regime switch in monetary policy since 1997, giving a clear increase in the level of central bank independence.

Findings

The theoretical framework suggests that an independent central banker could better manage inflation expectations and therefore inflation persistence despite the occurrence of persistent public investment shocks. From the perspective of fiscal policy, the appointment of a conservative and independent central banker could absorb adverse effects on inflation dynamics resulting from persistent expansionary fiscal policies. Empirical evidence in the UK indicates that the creation of an independent monetary policy committee reduces the positive link between public investment and inflation persistence.

Practical implications

From a monetary policy perspective view, the best response to public investment policies is to increase the degree of independence to alleviate effects on inflation dynamics. From the perspective of fiscal policy, an independent central banker can provide the necessary conditions to undertake a long-run public investment plan, since long-run growth will not be undermined by adverse inflation inertia.

Originality/value

The authors introduce, in the debate of inflation persistence, both theoretically and empirically, the role of public investment and monetary policy design.

Citation

Papadamou, S., Spyromitros, E. and Tsintzos, P. (2017), "Public investment, inflation persistence and central bank independence", Journal of Economic Studies, Vol. 44 No. 6, pp. 976-986. https://doi.org/10.1108/JES-10-2016-0214