the credibility of monetary reform: new evidence

The Credibility of Monetary Reform: New EvidenceAuthor(s): Andreas FreytagSource: Public Choice, Vol. 124, No. 3/4 (Sep., 2005), pp. 391-409Published by: SpringerStable URL: http://www.jstor.org/stable/30026725 .

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Public Choice (2005) 124: 391-409 DOI: 10.1007/si 1127-005-2055-1 © Springer 2005

The credibility of monetary reform - New evidence

ANDREAS FREYTAG Department of Economics, FSU Jena, Carl-Zeif3-Str 3, 07743 Jena, Germany E-mail: [email protected]

Accepted 18 May 2004

Abstract. The history of monetary policy is characterised by crisis and reform. The paper is dedicated to an explanation of what makes monetary reforms successful. A cross-sectional econometric analysis is chosen to deal with this problem. It is based on a standard macroeconomic model of commitment and credibility. As the dependent variable, we calculate a post-reform inflation rate. The exogenous variables are the degree of legal commitment, the constraining influence of institutions and a new variable for ex-ante credibility of the reform. The paper allows for the conclusion that monetary commitment, the consideration of institutional constraints and abstinence from the money press are crucial for the success of a monetary reform.

Introduction

Although the consciousness for monetary stability has grown in the last two decades, many countries still suffer from inflation. Moreover, it cannot be ruled out that inflation spurs again in the aftermath of the worldwide reces- sion of late 2001 through 2003. The need for monetary stabilisation programs probably will be prevalent in the future. Therefore, it makes sense to anal- yse past monetary reforms carefully. There is a considerable experience of monetary reforms: at the end of the twentieth century, one can look back on approximately 70 reform attempts since World War I. Many were successful, some failed. An eventual failure reduces the credibility of further efforts to stabilise the economy.

A monetary reform is necessary after a period of severe inflation, some- times hyperinflation. Typically, high inflation is caused by the inability of the government to cover its expenditure without printing money (Fischer, Sahay & Vegh, 2002). This causes inflation as well as future inflationary expectations in the public. The announcement of a monetary reform may lead to dynamic inconsistency if the public does not believe in the announcement. Therefore, the credibility and success of a monetary reform may not only depend on the choice of the right regime, but also on other factors. The hypothesis developed and tested here is that the institutional setting in the country or its economic order respectively plays a major role for the success of a monetary reform. The relationship between the de jure monetary commitment and de facto institutions is subject to closer scrutiny, as it seems crucial for the credibility of monetary commitment.



392

In the next section, we theoretically explain the incentives and constraints of a monetary policymaker after a monetary reform. These considerations form the basis for an econometric analysis of the determinants of success and failure of monetary reforms. We introduce the econometric model in the third section. In the fourth section, we present the results of a cross-sectional analysis using a sample of 29 reforms after World War II and discuss these. The final section is dedicated to economic policy conclusions.

The Theoretical Framework

Success and failure of monetary reform are theoretically best analysed using the standard framework of a utility maximising policymaker who acts under constraints (Barro, 1983; Barro & Gordon, 1983). They are politically best considered by the government through committing to a monetary regime, which is defined as the choice of a set of rules (Brennan & Buchanan, 1981: 65). Thus, commitment is made by governments rather than by monetary policymakers such as central bankers.' The main goal of commitment, i.e. of a reform, is to diminish inflationary expectations. We assume that the main reason for high inflation was the government's need for revenues (Bernholz, 1995: 263f). Other sources of revenues such as income tax or value-added tax proved insufficient to cover the government's expenditure.2 Therefore, it seemed attractive for the government to increase the money supply. It tried to issue enough money to maximise the amount of seigniorage S. Thus, the utility function of the government is as follows:

U(7r) = SrL(7te) - p(r) -* max, (1) 7r

where L(7re) is money demand, 7rL(Tre) represents seigniorage (Cagan, 1956) and yy(rt) reflects the costs of inflation. The weight the government places on seigniorage is denoted by S with 3 > 0. The government takes the expected inflation rate as given. Naturally, dL/dxr < 0 and dy/d7r > 0.

The solution under discretion is

(p'(7r) = SL(r), (2)

with Yr = 7e in equilibrium. The interpretation is simple: the marginal benefit of increasing the inflation rate (holding money demand constant) is equal to the existing stock of real balance, given by L(Jre) and weighted with the

government's inclination for seigniorage. This is equated to the marginal costs of inflation qp'(7r).

Replacing 7e by 7r in Equation (1) yields the following first-order condition

=o'(7r)/ =

L(r) + 7L'(xr) with (3)

*- '(7')/S - L(7r) 7r* = > 0. (4) L'(7r)



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The right-hand side of Equation (3) includes a term reflecting the fact that an increase in inflation will shrink the stock of real balances, reducing the base for the inflation tax. Taking this into account lowers the marginal benefit of inflation. The equilibrium rate will be lower. Nevertheless, the optimal inflation rate ir* is not time consistent, as dU/dcr, evaluated at 7*, is positive. Introducing a commitment mechanism may increase the costs of inflation yp(r) and, thus, reduce the politically optimal level of post-reform inflation.

The Econometric Analysis

In this section, the theoretical considerations are transformed into a framework for the estimations, and the results of the econometric analysis are presented and discussed. We have created a database consisting of 29 monetary reforms after World War II (Appendix B).

Political costs of inflation and credibility of a reform

First, the commitment mechanism is specified. The degree of legal monetary commitment MC is introduced as a means to increase the costs of inflation. The variable MC is a composed index, restricted between 0 and 1. It consists of the following 10 criteria, which contain all relevant legal information of monetary commitment (Freytag, 2001: 186-193; Table B2):

* Various objectives of monetary policy are likely, e.g. price stability, em- ployment, external equilibrium, etc. Commitment reaches its maximum, if price stability is the only goal (criterion obj).

* The monetary regime can be fixed on different constitutional levels, e.g. in the constitution, as central bank law or as a decree. The higher the constitutional level, the higher C(const).

* The lower the discretionary power left to the government, the higher the degree of commitment (gov).

* External obligations, like an external anchor or contingent help by the IMF or other IOs, also raise commitment (extern).

* The appointment and dismissal procedures of monetary policymakers have influence on the degree of commitment (ceo, diss).

* Limitations on lending to the government are important for the degree of commitment. If lending is allowed, commitment is low (lim).

* Convertibility restrictions also diminish the degree of commitment (conv, mult).

* Competitive elements, e.g. the permit to use foreign currencies beside the domestic one, in the monetary regime indicate a high degree of commitment (comp).



394

* Regulatory issues exert ambiguous influence of the degree of commitment (reg).

* The same holds for the accountability of the monetary authorities (acc).

The index of monetary commitment MC is calculated as the unweighted and weighted average of these criteria. (Table AI).3 The calculation of the index is comparable to the index of central bank independence as calculated by Cukierman (1992: 381). In contrast to the latter, MC contains information about external relations (Freytag, 2001). There are two theoretical reasons for this extensions: first, with a political decision about, the exchange rate regime or even the fix of the exchange rate, governments are able to counter the central bank's monetary policy - thereby seriously questioning central bank independence. Second, monetary reforms have often been backed by an exchange rate fix (nominal anchor); external aspects became constitutive elements of the new monetary commitment.

Theoretically, MC has a negative impact on inflation. It has to be empha- sised that MC reflects legal commitment. It does not measure the de facto monetary regime.

The legal commitment is ceteris paribus not a sufficient condition for success. There may be constraints that do not allow the commitment to become credible. To give an example: in a country with perfect unionisation and collec- tive bilateral wage negotiations, the government introduces a currency board to reduce the annual inflation rate from 200% close to zero inflation. Now, presume the negotiators do not consider the case of zero inflation while bar- gaining. This will cause unemployment to rise heavily unless the government inflates moderately. It then has the choice to follow a sustainable monetary policy (with rising unemployment) or to give up the currency board (with declining credibility). Taking the labour market regime into account from the beginning, would certainly lead to a different monetary regime through the reform.4

Consequently, we add in the de facto institutional setting in a country, consisting of formal and informal as well as politically created (economic order) and spontaneously evolved institutions. The institutional setting can be characterised by the following six institutional factors:

* Political stability is important to assess whether or not the economic order is likely to be subject to sudden changes. This implies that a political system is stable rather than long-term survival of a party in government.

* Fiscal stability is important, as only the strict separation of monetary and fiscal policy makes a monetary commitment credible.



395

* Openness of the country gives evidence of the extent to which the government relies on the world market price structures.

* Labour market flexibility is ideally measured by an index giving evidence of the duration of unemployment and the speed, with which structural change is managed on the labour market.

* Public attitude to inflation shows to what extent the public is willing to accept a stabilisation program. It comprises past experience and actual regulations.5

* If a fixed exchange rate regime is chosen, it makes sense to also consider properties of the reserve currency. It should not only be chosen to import stability, but also to protect the reform country from external shocks. This is given if a high share of foreign trade is either with the reserve country itself or with other countries having also fixed their exchange rate towards the reserve country (Freytag, 1998).

The theoretical impact of the institutional factors on inflation is negative, i.e. the higher political stability, fiscal stability, labour market flexibility, openness and public opposition to inflation are, the lower is the optimal inflation rate for the policymaker. However, given the difficulties to specify these variables unambiguously, we look for a comprehensive way to measure the institutional setting.

Such a measure is the index of economic freedom can be applied, which is intended to show inasmuch individuals are subject to governmental interven- tions into personal freedom. Economic freedom comprises personal choice, protection of private property and freedom of exchange (Gwartney, Lawson & Samida, 2000: 5; Appendix A). It at least reflects all institutional factors except for the properties of the reserve currency.

From the perspective of the government, a high degree economic freedom is restricting its ability to renege on the monetary commitment, as in such a case the individuals are able to move their property and capital abroad. To put it negatively, in the absence of economic freedom, governments face low political costs if they renege. Governments may for instance be tempted to start a political business cycle or to run social programs for the urban population prior to general elections. This can be at least made difficult by granting economic freedom. In addition, a government granting high economic freedom signals its willingness to stick to the commitment. Therefore, we assume that the index is a good approximisation to the institutional setting.

The index of economic freedom (EF) is calculated as the weighted average of seven groups of indicators, namely (1) size of government, (2) structure of the economy and the use of markets, (3) monetary policy and price stability, (4) freedom to use alternative currencies, (5) legal structure and property rights, (6) international exchange: trade and (7) freedom to exchange in capital



396

and financial markets. Naturally, to be useful for the goal of our analysis, the groups dealing with monetary policy (3, 4) have to be eliminated from the index, since monetary commitment has already been considered.

The final step to operationalise credibility is to model the relation between commitment and institutions. Monetary commitment is not a sufficient condition to generate credibility and subsequently stability. Rather, credibility is a function of the overall economic policy regime, more precisely the relation between the monetary regime introduced by the reform and institutional constraints. In other words: a high degree of commitment is likely to stabilise expectations if it is accompanied by high political stability, fiscal stability etc or a high degree of economic freedom. The resulting variable is an ex-ante proxy for credibility.6 Credibility is measured as the product of monetary commitment MC and the index of economic freedom EF (both between 0 and 1).

Cred = MC * EF. (5)

The expected correlation of Cred with inflation is negative, i.e. the higher the reform's credibility, the lower the politically optimal inflation rate.

Control variables for the success of monetary reform

Seigniorage In the theoretical model, the success of the reform also hinges on the degree to which the government needs seigniorage (8) and on the money demand. An actual attitude of the government towards seigniorage 8, naturally, cannot be observed.7 Instead, a measure of seigniorage itself has to be applied. There is no clear theoretical concept of seigniorage, the difficulty being to link monetary and fiscal aspects. Klein and Neumann (1990) incorporate both aspects and show that the correct magnitude of seigniorage transferred to the government cannot be determined by a simple formula such as the Cagan- type that we use in the theoretical considerations. The same holds for the two concepts of seigniorage which are generally used, the so-called oppor- tunity cost concept and the monetary seigniorage concept. Instead, a correct measure of seigniorage has to consider legal, institutional and operational details of money creation (Klein & Neumann, 1990). Only then the contri- bution of seigniorage to the public budget in different countries can be made

fully comparable. In a heuristic way, this is done constructing the variable SEIGN. It is calculated as the annual increase in base money over the sum of

public revenues and the annual increase in base money for the same year (see Appendix B). Thus, it captures the information about the demand for money and the dependence on seigniorage. The theoretically expected impact of this variable on the success of the reform is negative, that is the expected influence on inflation is positive.



397

External factors One factor that may also be important as a constraint for the policymakers is the effect of an external shock. The collapse of the Bretton-Woods system can be interpreted as being external shocks with a long-term effect. The variable PostBW is a dummy and measures the effect of the end of the Bretton-Woods system on the post-reform inflation rate. Its value equals 1 if the reform was made after 1973 and 0 if it was made until then. We expect a positive sign for PostBW, as the Bretton-Woods system may have had a disciplining effect on governments. Many countries had fixed their exchange rate towards the US$. This fixing gave a strong disincen- tive to raise inflation. But even without being part of the system, governments were always reminded of monetary discipline; which was not the case thereafter.8Consequently, the average inflation rate during the era of Bretton- Woods was lower than afterwards. Until 1973, average CPI in the world was below 10%. From 1974 until 1995 (with the exception of 1978) it was on the two-digit level. Only recently, average inflation moved beyond 10% again.9

Inflation as the dependent variable The rate of inflation after the monetary reform is the endogenous variable in the model. Policymakers announce a monetary policy, subsequently re- act to certain signals and choose an inflation rate that seems optimal from their personal perspective. In general, the variables are based on the concept of consumer price inflation (CPI). This is the best approximation, given the goal to break inflationary expectations in the public, and it is an interna- tionally comparable indicator. Moreover, the data are available for the whole sample.

It can hardly be expected that the annual inflation rates drop down close to zero within a year or even a shorter period after the reform. Inflationary expectations are very resistant, especially when the public has experienced a few unsuccessful reforms before. People are accustomed to rising prices. Moreover, many contracts may be indexed so that there is an inflationary pressure. Even if the monetary reform is credible, the stabilisation process will be time consuming. Thus, we assume a period of 5 years as being sufficient for the stabilisation process. It can be expected that a success of the reform will be visible within 5 years. Of course, disinflation can be achieved earlier with the inflation rate being low afterwards. Moreover, a failure can be identified easily within 5 years. Even if in the first few months or years after the reform, a slight stabilisation is observed, this period is long enough to recognise a failure. Hence, we use the average inflation rate during this period (ACPI). We use the logarithmic form of ACPI to properly consider the dynamics of the disinflation program.



398

Report and Discussion of the Empirical Results

Almost all reforms of the sample were implemented after periods of severe inflation. The majority took place in Latin America (Table B 1). We have tried to avoid a pre-selection bias through the inclusion of a number of reforms that could easily be identified as purely cosmetic undertakings (Mas, 1995). In Central and Eastern European transition countries, the original changes in the monetary regime during the transition process have not been included. Subsequent monetary reforms due to failures of these attempts have been considered.

A cross-sectional OLS estimation is applied.10 The goodness of fit of an OLS estimation depends crucially on whether the model is well specified. Problems may occur regarding heteroscedasticity, multicollinearity, linearity and stability of the parameters."

The results

The results of the empirical estimations are reported in Tables 1 and 2 as well as in Figures 1 and 2. The first hypothesis of this paper about the determinants

Table 1. Monetary commitment, institutions and inflation

Estimation 1 2 3 4

Dependent LnACPI LnACPI InACPI In ACPI

Intercept 4.13*** 3.06*** 8.5*** 7.87***

Commitment MC,, -7.31*** -3.9** Commitment MCw -5.98*** -2.81** EF -4.99*** -4.94***

Seigniorage SEIGN 5.94*** 6.51 3.77*** 4.18***

Dummy PostBW 2.98*** 3.23***

R2 adj. 0.74 0.73 0.80 0.77

Akaike info criterion (AIC) 3.06 3.11 2.42 2.53

F-Stat. 26.44 24.76 31.25 27.14

N 28 28 24 24

Source: Institute for Economic Policy (2001), Bernkopf (1999), New York

University Law School (1999), Aufricht (1962), Pick, IMF (b, c, d) Baihr (1994), Bennett (1993, 1994), Buch (1993), Cukierman (1992: 371-411), Fischer (1986), Fischer, Hiemenz and Trapp (1985), Cowitt, Greenwood (1983), Mastroberardino (1994: 161-171 and 187-197), and Schuler (1996). Some central bank laws and further information (Israel, Slovenia, Hong Kong, Ukraine) have been sent to the author upon request. *,** ,***: significant at 10, 5 and 1% level respectively; For an explanation of the variables see Appendices A and B.



399

Table 2. Credibility and inflation

Estimation 7 8 9 10

Dependent InACPI InACPI InACPI InACPI

Intercept 5.8*** 5.39*** 6.79*** 6.52***

Credw -7.42*** -8.53***

Credw -6.18*** -7.39***

SEIGN 4.5*** 5.04***

R2 adj 0.77 0.75 0.66 0.62

Akaike info criterion (AIC) 2.47 2.61 2.82 2.97

F-Stat. 41.59 34.74 49.31 39.62

N 24 24 25 25

Source: see Table 1.

*,** ,*** indicate significance at 10, 5 and 1% level, respectively; For an explanation of the variables see Appendices A and B.

of the average inflation after monetary reforms cannot be rejected by the results of estimations 1 and 2. The index of commitment regardless of the chosen weighting (MCuw or MCw) and seigniorage (SEIGN) both show the expected sign and are significant on the 1% level. The unweighted average has a higher explanatory power. The higher the degree of commitment, the lower the average inflation. The politically optimal inflation is positively dependent on monetary seigniorage.

Figure 1 underpins these results graphically. The diversity of the sample makes it difficult to rule out that the results are driven by one or two outliers. Obviously, this is not the case. The general picture is clear: higher monetary commitment through the reform increases the probability of a successful reduction of inflation.

In estimations 1 and 2, the dummy for the post Bretton-Woods era, PostBW, is included. The sign of its coefficient is positive. Very cautiously, this evidence can be interpreted as follows: the Bretton-Woods system with its fixed exchange rate exerted a disciplinary pressure on governments, in particular in countries with a fixed dollar exchange rate. Higher inflation than in the United States regularly forced these countries to devalue their currencies towards the US$. This certainly had disciplinary effects. After 1973, the exchange rates became flexible. It also became easier to produce high inflation rates without the external anchor. Furthermore, the reform countries were subject to supply shocks after 1973. PostBW does not separate between these two effects.12

Second, we test whether institutions, specified as index of economic freedom EF, also are relevant. The estimation results are also reported in Table 1.



400

MC

.9-

.8-

.7-

.6-

.5-

.4-

.3 -

.2 -

.1- -1 0 1 2 3 4 5 6 7 8

In ACPI

Figure 1. Monetary commitment and inflation.

Cred

.7-

.6-

.5-

.4 -

.3-

.2 -

.1 -

.0- -1 0 1 2 3 4 5 6 7 8

In ACPI

Figure 2. Credibility and inflation.

The index of commitment and SEIGN loose weight if EF is added (the overall quality if the estimation has improved in comparison with estimations 1 and 2, see AIC). Economic freedom has the expected negative sign and is significant (estimations 3 and 4). The degree of economic freedom exerts a negative influence on the post-reform inflation.

Finally, the influence of the ex-ante proxy for credibility (Cred) on post- reform inflation is tested. Table 2 indicates that the theoretical considerations



401

hold: the higher the ex-ante credibility of a monetary reform, the lower the politically optimal inflation rate. The results are more significant and have higher explanatory power than those in Table 1. As before, the unweighted index of monetary commitment is better, as estimations 5 and 6 display. Es- timations 7 and 8 show that the effect of the control variable SEIGN is not negligible.

Again, these results are illustrated in Figure 2. The strong negative relation between ex-ante credibility of the reform and post-reform inflation is visible.

Discussion of the results

Before we begin with the assessment of the empirical section, we have to consider the diversity of the sample. It consists of reforms pursued within three continents and over almost 50 years. In addition, average post-reform inflation rate varies between 1% and more than 1,300%. First, heteroscedasticity, i.e. the fact that the variances of the residuals are not uniform, cannot be ruled out. If the absolute magnitude of the residuals varies with the magnitude of the variables, both dependent and independent, heteroscedasticity occurs. It leads to still unbiased but inefficient estimators. Their variances are bigger than those without heteroscedasticity. The sample of 29 monetary reforms is very heterogeneous as regards the magnitude of the variables. In some estimations heteroscedasticity occurred. White's heteroscedasticity test and if necessary White's correction for heteroscedasticity are applied.13

Other problems concern the stability and linearity of the parameters. It is assumed that the correlation between explanatory variables and the dependent variable is linear. This needs to be tested. We apply several stability tests to check whether the parameters are robust, e.g. the cusum of square-test and recursive residuals. Moreover, subsamples, are estimated separately, e.g. the Latin American countries. We also test whether it is critical to drop countries that do not perfectly correspond with the theory such as Germany (1990) and Hong Kong (1983). In both cases, hyperinflation was not the cause of the reform. As a general result, the parameters have proven robust in these tests. For the choice of the variables, we also calculate the correlation coefficient of the regressors. In general, it is low.

The econometric analysis confirms the theoretical considerations about the determinants of the post-reform inflation rates. An important independent variable is monetary commitment (MC). It has a great impact on the post reform inflation rate: its fl-value indicates that an increase in commitment leads to relatively decreasing inflation. Hence, the design of the monetary regime surely matters for the success of the reform.

In addition, economic freedom is relevant, in other words: institutions mat- ter. The degree of economic freedom EF has even a higher impact on inflation



402

than has monetary commitment.'4 The most relevant variable, however is ex-ante credibility, the product of EF and MC. Thus, the theoretical considerations cannot be rejected. Credibility and therefore success of reform depends on both commitment and institutions.

The control variables also provide some explanation, in particular SEIGN. This upshot is not new; rather, it can be regarded as being another confirma- tion of the generally accepted insight that solving fiscal problems via money growth causes inflation. The strict separation of fiscal and monetary policy is certainly one important prerequisite for the success of a monetary reform. In many (successful) instances of the sample, the outcome of the variable changes considerably after the monetary reform. For instance, Argentina reduced its reliance on money growth from a value of SEIGN of 0.5 prior to 1991 to a value of 0.01 a few years later. The absence of seigniorage does not imply fiscal stability at any rate. The correlation between fiscal stability measured as budget deficit over GDP (8-year average; Freytag, 2002: 218) and SEIGN in the sample is low (0.1556), which makes sense eco- nomically. It shows that public deficits as such do not necessarily endan- ger the success of a reform, as long as the deficit is financed on the capital market.

The performance of the dummy PostBW has an interesting lesson: the probability of a monetary reform to fail rises in the aftermath of supply shocks and without the disciplining structure of the Bretton-Woods system. The international attitude towards inflation obviously influences the policymakers' decision to create stability.

Policy Conclusions

This paper has shown the causes of success and failure of monetary reforms in a positive analysis. The main objective of such an analysis is to generate potentially successful reform options for a country suffering from severe inflation. Needless to say that for a precise and credible reform recommen- dation, it is necessary to also consider detailed institutional circumstances of the country, which cannot be adequately covered by the institutional factors defined in this study, even if superior data were available. The situation in

reality is considerably more complex than suggested by any model. Notwith-

standing, the econometric analysis clearly marks the central requirements of monetary reforms. Therefore, the econometric model presented here is

helpful for a deeper analysis of the economic situation in a potential reform

country. So the policy conclusions are that four elements are crucial for a monetary

reform to be successful: first, international spillovers play a role, in this case a negative role. This is very interesting from the policymaker's point of view. For - on the other hand - international monetary discipline or international



403

agreement can increase the probability of a success of reforms. Monetary reformers can for instance make use of the scapegoat function of international organisations (Vaubel, 1986). Second, a monetary reform undoubtedly fails if the government is unable to generate revenues from other sources than the money press. Third, a strong commitment to stability in the legal monetary regime established by the government can prevent the monetary policymaker from inflating. Finally, institutional factors certainly restrict the government's choice of an appropriate monetary regime. Monetary policy is only one part of the economic order. It is more credible if accompanied by other elements of policy assignment. The interdependence of its elements has to be considered when reforming parts of the economic order.

Acknowledgements

Financial support by the Otto Wolff-Stiftung is gratefully acknowledged. Thanks are also due to Bettina Becker, Juergen B. Donges, David Fand, Ken Kuttner, David Laidler, Stefan Mai, Friedrich Schneider, Pia WeiB, C. Christian von Weizsdicker and John Wood, as well as seminar par- ticipants at the universities of Bamberg, Cologne, Duisburg, G6ttingen, Jena, Mtinster, Kassel and Wuppertal, at the Public Choice Society An- nual Meeting 2000 in Charleston, SC, as well as the Annual Meeting of the Verein fur Socialpolitik 2000 in Berlin for helpful comments on earlier versions.

Notes

1. Cukierman (1992: 53) also concludes that this is adequate. See also McCallum (1997). 2. Another motive of the government can be debt reduction, which can be incorporated into

Equation (1). Instead of raising revenues to pay off debt, the debt will be reduced via money growth.

3. The construction and weighting of composed indices bears the danger of arbitrariness. We try to avoid this by a careful analysis of the underlying institutional economics of this concept (Freytag, 2001).

4. There is a growing concern for the role of institutions in monetary policy. See e.g. Keefer and Stasavage (2001).

5. Hayo (1998) shows that the inflation culture is subject to a feedback process. Low inflation causes public opposition against inflation, which on the other hand is a cause for future stability. We follow the second part of the argument, but not the first, although it sounds plausible, in particular for industrial countries. Our argument is that the experience with very high and volatile inflation causes people to get tired of inflation. See also Grtiner, 1998 and Fischer, 1983.

6. For a general discussion see Freytag (2002: 98-102). 7. This holds regardless of whether or not the government has committed to a rule that

abolishes direct loans received from the monetary authority.



404

8. Interpreted as such, the dummy is a crude substitute for the institutional setting. Conse- quently, we do not estimate both jointly.

9. Theoretically, the increasing average inflation rate can also be traced back to the huge price increase of oil in 1973/74 and 1979/80 respectively (IMF (a), here: October 1996: 100f).

10. The computation is carried out with EViews 4.1. 11. For a general overview, see Kennedy (1992, in particular the synopsis on p. 45). Therefore,

we have also applied a completely different approach, namely a binary choice model to control for the results of the OLS procedure. However, the results are completely meaning- less, so that we do not report them here. For a critique of binary choice models see Greene (1997: 880f).

12. The increasing capital mobility related to the post Bretton-Woods era has not become a

similarly disciplining institution. 13. The interesting feature about White's correction is that even in the presence of heteroscedas-

ticity the OLS method can produce consistent estimators (White, 1980). The computational task can be handled more easily than with a GLS estimation (Kennedy, 1992: 118f).

14. This may partly be due to the fact that group 7 of the index of economic freedom contains some of the elements of MC (Appendix B).

15. This reflects theoretical reasoning about the sources of inflation. For details see Freytag (2001: 198f).

Appendix A

The index of commitment

To measure the degree of commitment, an index of commitment has been constructed along the lines of an index of central bank independence (Cukierman, 1992). It is the (unweighted and weighted, Table Al) average of 10 criteria that characterise the monetary regime. The

Table Al. Weights given to the components

Component Unweighted (C,,) Weighted (Cw)

Criterion 1. Objectives Obj 0.10 0.15

2. Constitutional level Const 0.10 0.05

3. Discretionary power Gov 0.10 0.15

4. External obligations Extern 0.10 0.15

5. Appointment/dismissal Ceo 0.05 0.025

Procedures Diss 0.05 0.025

6. Limitations on lending Lim 0.10 0.20

7. Convertibility restrictions Conv 0.05 0.10

Mult 0.05 0.05

8. Competitive elements Comp 0.10 0.05

9. Regulatory issues Reg 0.10 0.025

10. Accountability Acc 0.10 0.025

Sum 1.00 1.00



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unweighted index of commitment Cuw attributes the same weight to each of the 10 criteria. In contrast, the weighted index C, attributes more weight to the objectives of monetary policy, governmental influence, external obligations, convertibility and limitations on lending to the government. Less weight is given to appointment and dismissal procedures, competitive elements, regulatory issues and accountability.15

Institutional factors The index of economic freedom, EF. It is calculated as the weighted average of five groups (except for monetary policy and alternative currencies, which are subject to explanation) of the 2000 index of economic freedom by Gwartney, Lawson and Samida (2000: 7), composed of 23 components in seven groups:

1. Size of government, 2 components, 11%. 2. Structure of the economy and the use of markets, 4 components, 14.2%. 3. Monetary policy and price stability, 3 components, 9.2% (omitted). 4. Freedom to use alternative currencies, 2 components, 14.6% (omitted). 5. Legal structure and property rights, 3 components, 16.6%. 6. International exchange: trade, 5 components, 17.1%. 7. Freedom to exchange in capital and financial markets, 4 components, 17.2%.

(G1 *0.11 + G2 * 0.142 + G5 ,*0.166 + G6 * 0.171 + G7 * 0.172)GLS EF = 0.762 * 10

Control variables

The other exogenous variables are explained in the third section. SEIGN is the average of seigniorage in 5 years after the reform, M denotes the money base, R stands for revenues.

SEIGN = 1/5* M

PostBW = 0, if t < 1973, and PostBW = 1, if t > 1973.

The dependent variable

Inflation is calculated as an average inflation rate of the 5 years after the reform.

ACPI = ((Pt+5/Pt)0.2 - 1) * 100

Appendix B: The Sample of 29 Monetary Reforms

The sample does not contain former socialist countries introducing a new monetary regime during the transformation process. After a failure of the new regime in Estonia, Lithuania, Latvia, Slovenia, Russia and the Ukraine, a monetary reform as defined here became necessary in these countries. Those reforms are considered in the sample.



406

Table B1. Pre-reform inflation, monetary regimes and the degree of commitment in the sample

Countries Year CPI in t - 1 Monetary regime Cuw Cw CPI in t to t + 5

Argentina 1991 2,313.7 Currency Board 0.798 0.873 8.3

Argentina 1985 549.4 CB, fixed ER 0.462 0.462 577.6

Bolivia 1987 277 CB, fixed ER 0.540 0.466 16.3

Bolivia 1963 5.9 CB, fixed ER 0.540 0.466 7.3

Brazil 1994 1,000 CB, fixed ER 0.495 0.482 113.8

Brazil 1989 1,431.7 CB, flexible ER 0.238 0.188 736.9

Brazil 1986 226.1 CB, fixed ER 0.346 0.317 1,310.7 Chile 1975 511.1a CB, fixed ER 0.474 0.350 78.6

Estonia 1992 1,069a Currency Board 0.787 0.837 37.6

Germany 1990 n.a. CB, flexible ER 0.665 0.649 3.5

Germany 1948 25.4 CB, fixed ER 0.707 0.712 1.0

Greece 1954 9.1 CB, flexible ER 0.424 0.312 3.1

Hong Kong 1983 10.1a Currency Board 0.674 0.804 5.8

Israel 1985 374.9 CB, fixed ER 0.503 0.478 23.8

Israel 1980 75.0 CB, flexible ER 0.495 0.411 196.5

Korea 1962 12.1 CB, fixed ER 0.441 0.308 18.9

Latvia 1992 243.6a CB, flexible ER 0.632 0.628 35.2

Lithuania 1994 409.7a Currency Board 0.715 0.829 27.9

Mexico 1993 15.5 CB, fixed ER 0.628 0.641 22.1

Mexico 1987 87.3 CB, fixed ER 0.378 0.291 35.8

Nicaragua 1990/91 7,475,8 CB, fixed ER 0.662 0.649 14.5

Nicaragua 1988 911,5 CB, fixed ER 0.441 0.358 1,009.2 Peru 1991 7,592.3 CB, flexible ER 0.578 0.624 31.7

Peru 1985 110,5 CB, fixed ER 0.445 0.383 823.3

Russia 1994 874.6 CB, fixed ER 0.611 0.632 59.2

Slovenia 1991 n.a. CB, flexible ER 0.511 0.507 18.2

Ukraine 1992 n.a. CB, fixed ER 0.187 0.266 215.2

Uruguay 1993 68.4 CB, fixed ER 0.457 0.425 28.5

Uruguay 1975 77.3 CB, fixed ER 0.440 0.391 56.5

Note. CB = central bank; ER = exchange rate. Source: See Table 1. aCPI in t.



407

Table B2. The individual components of monetary commitment

Country Obj Const Gov Extern Ceo Diss Lim Conv Mult Comp Reg Acc

Argentina 1.00 0.66 1.00 1.00 1.00 1.00 0.66 1.00 1.00 0.66 0.00 1.00

Argentina 0.50 0.33 0.00 0.75 0.00 1.00 0.33 0.75 1.00 0.33 0.00 1.00 Bolivia 0.50 0.66 0.00 0.75 1.00 1.00 0.00 1.00 1.00 0.33 0.50 0.66 Bolivia 0.50 0.66 0.00 0.75 1.00 1.00 0.00 1.00 1.00 0.33 0.50 0.66 Brazil 0.50 0.66 0.66 0.75 0.00 0.00 0.00 0.75 1.00 0.00 0.50 1.00 Brazil 0.50 0.00 0.00 0.00 0.00 0.00 0.00 0.75 0.00 0.00 0.50 1.00 Brazil 0.50 0.33 0.00 0.75 0.00 0.00 0.00 0.75 0.00 0.00 0.50 1.00 Chile 0.50 0.66 0.00 0.75 0.00 1.00 0.00 0.00 1.00 0.33 0.50 1.00 Estonia 0.50 0.66 1.00 1.00 1.00 1.00 1.00 0.75 1.00 0.33 0.50 1.00

Germany 0.50 0.66 0.66 0.00 0.00 1.00 1.00 1.00 1.00 0.33 1.00 1.00

(East) Greece 1.00 0.66 0.00 0.00 0.00 0.50 0.33 0.00 0.00 0.00 1.00 1.00

Hong Kong 0.50 0.33 1.00 1.00 0.00 0.50 1.00 1.00 1.00 0.33 1.00 0.33 Israel 0.50 0.66 0.33 0.75 0.00 0.50 0.33 0.75 0.00 0.33 0.50 1.00 Israel 0.50 0.33 0.33 0.00 0.00 0.50 0.33 0.75 1.00 0.33 1.00 1.00 Korea 0.50 0.66 0.00 0.75 1.00 1.00 0.00 0.00 0.00 0.00 0.50 1.00 Latvia 1.00 0.66 1.00 0.00 0.00 1.00 0.33 1.00 1.00 0.33 0.50 1.00 Lithuania 0.50 0.66 1.00 1.00 0.00 1.00 1.00 1.00 1.00 0.33 0.50 0.66 Mexico 0.00 0.66 0.00 0.75 0.00 1.00 0.00 0.75 0.00 0.33 0.50 0.66 Mexico 0.50 0.66 1.00 0.75 1.00 1.00 0.33 0.75 1.00 0.00 0.50 0.66

Nicaragua 0.50 0.66 1.00 0.75 1.00 1.00 0.33 0.75 1.00 0.00 0.50 1.00

Nicaragua 0.50 0.33 0.00 0.75 1.00 1.00 0.33 0.00 0.00 0.00 0.50 1.00

Paraguay 0.50 0.66 0.66 0.75 1.00 1.00 0.00 0.75 1.00 0.00 0.50 1.00 Peru 1.00 0.66 1.00 0.25 1.00 0.00 0.33 0.75 1.00 0.33 0.50 0.33 Peru 0.50 0.66 0.00 0.75 1.00 1.00 0.00 0.75 0.00 0.33 0.50 0.33 Russia 0.50 0.66 1.00 0.75 0.00 1.00 0.33 0.75 1.00 0.33 0.50 0.66 Slovenia 0.50 0.66 1.00 0.00 0.00 0.50 0.33 0.75 1.00 0.33 0.50 0.66 Ukraine 0.00 0.00 0.66 0.50 0.00 0.00 0.00 0.75 0.00 0.33 0.00 0.00

Uruguay 0.50 0.66 0.00 0.75 0.00 1.00 0.00 1.00 1.00 0.00 0.50 0.66

Uruguay 0.50 0.66 0.00 0.75 0.00 1.00 0.00 1.00 0.00 0.33 0.50 0.66

Source: see Table 1.



408

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