Corruption and Monetary Policy

Abstract

The level of corruption varies widely across countries. This paper examines the consequence of corruption for the design of monetary policy. We employ an extended Barro-Gordon framework a la Alesina and Tabellini (1987) and model corruption as a leakage of tax revenue. There are several important implications from the model. First, the optimal inflation targeting for a high-corruption country is generally different from that for a low-corruption country. A mechanical inflation target (i.e., the 1-3% range typically advocated to most countries in the world) could reduce social welfare. Second, corruption can be viewed as one source of lack of commitment. Fixed exchange rates or currency boards are more difficult to sustain for high-corruption countries as the inflation rate (in the anchor country) may be too low from the viewpoint of the countries that adopt the exchange rate arrangements. Third, while inflation rate generally rises with the level of corruption under a commitment regime, it may fall or rise with corruption under a discretionary regime, depending on the initial level of corruption. Despite of this, a commitment regime generally generates a higher level of welfare than an ordinary discretionary regime. Fourth, a Rogoff-style conservative central banker can outperform a fixed exchange rate regime, a mechanical inflation target, currency board or dollarization. However, the optimal degree of conservatism is an inverse function of the corruption level. In the extreme case in which corruption is so severe that the tax system breaks down completely, the optimal degree of conservatism is zero.