Macroeconomic risk and central bank independence: Improved estimates on the influence of central bank independence on inflation variability and taxes

The central bank independence (CBI) literature provides theoretical expositions and empirical evidence that show an inverse relationship between the degree of CBI on the one hand and the level and stability of inflation on the other. This dissertation develops a functional form that relates CBI to the first and second moments of inflation rates. Evidence obtained in this study suggests that the aforementioned functional form fits a relationship between the degrees of CBI and the second moment of unexpected inflation rates. Unlike existing empirical studies that employ OLS-based models, this study uses a maximum likelihood framework that facilitates the direct inclusion of CBI parameters in the residual covariance matrix. This new approach allows for a more intensive use of information contained in the CBI indexes and the estimates obtained are perhaps more better reflective of CBI influences. Employing this new approach, I examine the influence of CBI on the revenue-smoothing hypothesis. This hypothesis posits that an optimizing government will adjust both inflation and taxes to meet shocks to government spending. Results obtained provide evidence confirming the CBI-inflation relationship and also the revenue-smoothing hypothesis. Some evidence, not entirely conclusive, obtained in the latter test suggests the existence of a positive relationship between taxes and the level of CBI.