THE IMPACT OF INSTITUTIONAL QUALITY ON MONETARY POLICY RESPONSE FUNCTION: EVIDENCE FROM DEVELOPED AND DEVELOPING ECONOMIES

Abstract

There is a plethora of empirical evidence available which postulates that the central banks across the world respond asymmetrically to inflation. The response of monetary authorities toward inflation changes, when it reaches a threshold level. After estimating the nonlinear Taylor rule for 51 countries over the period of 1983–2015, including 28 advanced economies and 23 emerging and developing economies, we come to the conclusion that the quality of political institutions has a significant impact on the threshold level of the inflation rate. In contrast to the countries with weak institutional quality, countries with high institutional quality have a very low level of inflation rate where monetary authorities change their behavior. Our finding further reveals that the countries with low corruption, stable governments, efficient bureaucracy and good socio-economic conditions have a very low level of inflation rate. Central banks respond aggressively in these countries when inflation exceeds a threshold level inflation rate. The socio-economic condition index has a greater impact on the inflation threshold level as compared to other sub-indexes of institutional quality. The findings imply that the improvement in institutional quality enables the central banks to keep inflation at a low level.