Central Bank Independence, Transparency, and Interaction with Fiscal Policy: The Case of a Small Open Economy

Key findings from this study

• The study found that legal central bank independence without fiscal discipline fails to reduce inflation volatility and may marginally increase fluctuations in binary regime specifications.
• The researchers demonstrate that central bank independence substantially reduces inflation volatility only when implemented under fiscal pressure conditions, indicating complementarity between monetary credibility and fiscal constraint.
• The authors report that economic transparency increases short-term volatility but stabilizes inflation exclusively when supported by credible fiscal signals rather than operating in isolation.

Overview

This study investigates inflation volatility determinants in Tunisia by analyzing central bank independence (CBI), economic transparency, and macroeconomic fundamentals. The research develops a game-theoretic framework to model how transparency and CBI effectiveness influence welfare outcomes for both monetary and fiscal authorities. Two empirical approaches capture different analytical dimensions: a binary threshold nonlinear autoregressive distributed lag model identifies long-run relationships, while a Markov-switching GARCH framework models volatility dynamics.

Methods and approach

The authors employ a binary threshold NARDL model to examine long-run relationships between CBI, transparency, and inflation volatility. A Markov-switching GARCH framework captures the time-varying nature of volatility dynamics. The theoretical component uses game theory to illustrate interactions between central bank independence, transparency, and fiscal policy coordination. The analysis treats CBI both as a continuous measure and as a binary regime variable to assess differential effects.

Results

As a continuous measure, CBI demonstrates no statistically significant impact on inflation volatility. Conversely, high de jure independence measured as a binary regime associates with a modest increase in inflation fluctuations, suggesting that legal independence alone lacks efficacy absent fiscal discipline or effective monetary-fiscal coordination. Under fiscal pressure conditions, greater CBI substantially reduces inflation volatility, indicating that institutional effectiveness depends critically on macroeconomic policy coherence.

Economic transparency exhibits dual effects: it increases short-term volatility but stabilizes inflation when paired with credible fiscal signals. Broad money volatility emerges as strongly destabilizing, while fluctuations in industrial production and real exchange rates prove largely insignificant. Government spending and external shocks amplify inflation volatility. A negative trend in volatility over the sample period reflects accumulated benefits from policy reforms.

Implications

The findings challenge conventional views that legal central bank independence mechanically improves monetary stability in small open economies. Institutional frameworks require complementary fiscal discipline and explicit coordination mechanisms to realize independence benefits. Policymakers must prioritize establishing genuinely credible monetary institutions alongside coherent macroeconomic frameworks rather than pursuing independence as an isolated objective.

Transparency strategies merit careful calibration given their initial destabilizing effects. Enhanced communication must be paired with demonstrated fiscal credibility to generate stability benefits. The destabilizing role of broad money volatility and external shocks underscores the importance of strengthening financial system risk management and external vulnerability resilience. Policy coordination between monetary and fiscal authorities constitutes a prerequisite for effective inflation management in small open economies facing fiscal constraints.

Scope and limitations

This summary is based on the study abstract and available metadata. It does not include a full analysis of the complete paper, supplementary materials, or underlying datasets unless explicitly stated. Findings should be interpreted in the context of the original publication.