Corruption and Monetary Policy 1

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 in‡ation targeting for a high-corruption country is generally different from that for a low-corruption country. A mechanical in‡ation 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 di¢cult to sustain for high-corruption countries as the in‡ation rate (in the anchor country) may be too low from the viewpoint of the countries that adopt the exchange rate arrangements. Third, while in‡ation 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 Rogo¤-style conservative central banker can outperform a …xed exchange rate regime, a mechanical in‡ation target, currency board or dollarization. However, the optimal degree of conservatism is an inverse function of the corruption level. In 1 We would like to Peter Clark and Paul Masson for useful conversations, and Hayden Smith for editorial assistance. All remaining errors are our own. The views expressed here are those of the authors and do not necessarily represent those of their a¢liated institutions. 2