Central Bank Independence Promotes Budgetary Efficiency

This paper shows theoretically that inefficient public expenditure can be institutionally curtailed by an independent central bank. An advantage of our analysis is to employ a two-country model with cash-in- advance constraints. The model can deal with fiscal policy as well as monetary policy with considering international interdependence. Each government decides the levels of public goods provision and a lump-sum tax, and each central bank chooses the quantity of money supply, to maximize its own households' utility. When the central bank is not independent of the fiscal authority, that is, when fiscal policy is determined before monetary policy, the public good is oversupplied. When the central bank is independent (monetary policy is predetermined), however, the expenditure level is efficient. Because the government cannot decide the provision of public good in anticipation of seigniorage. Thus, an independent central bank can promote cuts of budgetary inefficiency.