Central bank independence and financial instability

It has been argued that central bank independence (CBI) may not only be beneficial for reaching the objective of price stability, but also for maintaining financial stability. Greater independence from external pressure implies that central banks are less politically constrained in acting to prevent financial distress, while it also will allow them to act earlier and more decisively when a crisis erupts. We estimate the relation between CBI and a newly constructed measure of financial instability using a dynamic panel model for the period 1985-2005 with a large set of control variables. We find a significant and robust negative relation between CBI and financial instability, which is mostly due to political independence. (C) 2008 Elsevier B.V. All rights reserved.