THE WORLD BANK Public Disclosure Authorized ECONOMIC REVIEW Volume 6 September 1992 Number 3 Measuring the Independence of Central Banks and Its Effect on Policy Outcomes Alex Cukierman, Steven B. Webb, and Bilin Neyapti On the Transmission of World Agricultural Prices Public Disclosure Authorized Yair Mundlak and Donald F. Larson How Small Enterprises in Ghana Have Responded to Adjustment William F. Steel and Leila M. Webster The Dynamics of Optimal Gradual Stabilizations Alex Cukierman and Nissan Liviatan Uniform Commercial Policy, Illegal Trade, and the Real Exchange Rate: A Theoretical Analysis Stephen A. O'Connell Public Disclosure Authorized Maize and the Free Trade Agreement between Mexico and the United States Santiago Levy and Sweder van Wijnbergen The Optimal Currency Composition of External Debt: Theory and Applications to Mexico and Brazil Stijn Claessens Household Saving in Developing Countries: First Cross-Country Evidence Klaus Schmidt-Hebbel, Steven B. Webb, and Giancarlo Corsetti Cumulative Indexes of Articles and Authors for Volume 6 Public Disclosure Authorized THE WORLD BANK ECONOMIC REVIEW EDITOR Ravi Kanbur CONSULTING EDITOR Sandra Gain EDITORIAL BOARD Kaushik Basu, University of Delhi John Holsen Guillermo Calvo, International Monetary Fund Gregory K. Ingram Alberto Giovannini, Columbia University Ravi Kanbur Mark R. Rosenzweig, University of Pennsylvania Mieko Nishimizu Joseph Stiglitz, Stanford University Jacques van der Gaag Sweder van Wijnbergen The World Bank Economic Review is a professional journal for the dissemination of World Bank-sponsored research that informs policy analyses and choices. It is directed to an interna- tional readership among economists and social scientists in government, business, and interna- tional agencies, as well as in universities and development research institutions. 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Permission to make photocopies is granted through the Copyright Clearance Center, 27 Congress Street, Salem, MA 01970 U.S.A. This journal is indexed regularly in Current Contents/Social & Behavioral Sciences, Index to International Statistics, Journal of Economic Literature, Public Affairs Information Service, and Social Sciences Citation Index®. It is available in microform through University Microfilms, Inc., 300 North Zeeb Road, Ann Arbor, Michigan 48106, U.S.A. THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3: 353-398 THE WORLD BANK ECONOMIC REVIEW Volume 6 September 1992 Number 3 Measuring the Independence of Central Banks and Its 353 Effect on Policy Outcomes Alex Cukierman, Steven B. Webb, and Bilin Neyapti On the Transmission of World Agricultural Prices 399 Yair Mundlak and Donald F. Larson How Small Enterprises in Ghana Have Responded 423 to Adjustment William F. Steel and Leila M. Webster The Dynamics of Optimal Gradual Stabilizations 439 Alex Cukierman and Nissan Liviatan Uniform Commercial Policy, Illegal Trade, and the Real 459 Exchange Rate: A Theoretical Analysis Stephen A. O'Connell Maize and the Free Trade Agreement between Mexico 481 and the United States Santiago Levy and Sweder van Wijnbergen The Optimal Currency Composition of External Debt: 503 Theory and Applications to Mexico and Brazil Stijn Claessens Household Saving in Developing Countries: 529 First Cross-Country Evidence Klaus Schmidt-Hebbel, Steven B. Webb, and Giancarlo Corsetti Cumulative Index of Articles and Authors for Volume 6 549 THE WORLD BANK ECONOMIC REVIE W. VOl.. 6. NO. 3: 353-395 Measuring the Independence of Central Banks and Its Effect on Policy Outcomes Alex Cukierman, Steven B. Webb, and Bilin Neyapti Making the central bank an agency with the mandate and reputation for maintaining price stability is a means by which a government can choose the strength of its commit- ment to price stability. This article develops four measures of central bank indepen- dence and explores their relation with inflation outcomes. An aggregate legal index is developedforfour decadesin 72 countries. Three indicatorsof actual independenceare developed: the rate of turnover of central bank governors, an index based on a ques- tionnaire answered by specialistsin 23 countries, and an aggregationof the legal index and the rate of turnover. Legal independence is inversely related to inflation in industrial, but not in develop- ing, countries. In developing countries the actual frequency of change of the chief executive officer of the bank is a better proxy for central bank independence. An inflation-based index of overall central bank independence contributes significantly to explaining cross-country variationsin the rate of inflation. "Willpower is trying hard not to do something that you really want to do," said Frog. "Youmean like trying not to eat all these cookies," asked Toad. "Right," said Frog. He put the cookies in a box. "There, now we will not eat any more cookies." "But we can open the box," said Toad. "That is true," said Frog. He tied some string around the box. He got a ladder and put the box up on a high shelf. "There, now we will not eat any more cookies." "Butwe can climb the ladder. ." (Lobel1972) Institutions cannot absolutely prevent an undesirable outcome, nor ensure a desirable one, but the way that they allocate decisionmaking authority within the public sector makes some policy outcomes more probable and others less likely. An important example of this principle concerns the balance of authority between the central bank and the executive and legislative branches of govern- ment. Economists and practitioners in the area of monetary policy generally Alex Cukierman is with the Department of Economics,Tel Aviv University;Steven B. Webb is with the Country Economics Department at the World Bank; and BilinNeyapti is with the Country Economics Department at the World Bank and the Economics Department, Universityof Maryland. © 1992 The International Bank for Reconstructionand Development/THEWORLD BANK 353 354 THE WORLD BANK ECONOMIC REVIEW, VOL. 6. NO. 3 believe that the degree of independence of the central bank from other parts of government affects the rates of expansion of money and credit and, through them, important macroeconomic variables, such as inflation and the size of the budget deficit. Ultimately, the central bank's authority and scope of action depends on the government. But governments often pass laws and follow customs that grant their central banks authority and autonomy to pursue price stability, even when it conflicts with other government objectives. Making the central bank an agency with the mandate and reputation for maintaining price stability benefits the economy and the government itself in various ways. Central bank indepen- dence is one of the means by which a government can choose the strength of its