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

This study examines the determinants of inflation volatility in Tunisia, focusing on central bank independence (CBI), economic transparency, and macroeconomic fundamentals. Although CBI is widely regarded as essential for monetary credibility, its effectiveness depends on its institutional framework. Our contribution is twofold. First, we develop a theoretical framework based on game theory to illustrate how the effectiveness of economic transparency and CBI shapes the welfare of both the central bank and the private sector in the presence (or not) of fiscal policy. Second, we use a binary threshold nonlinear autoregressive distributed lag (NARDL) model to capture long-run relationships and a Markov-switching GARCH (MS-GARCH) framework to model volatility dynamics. As a continuous measure, CBI has no significant impact on volatility. Paradoxically, high de jure independence in a binary regime is associated with a slight increase in inflation fluctuations. This indicates that legal independence alone is insufficient without fiscal discipline or effective coordination between the monetary and fiscal authorities. Notably, under fiscal pressure, greater CBI substantially reduces inflation volatility, highlighting the need for a coherent macroeconomic framework. Economic transparency generally increases short-term volatility but stabilizes inflation when supported by credible fiscal signals. Among the macroeconomic fundamentals, volatility in broad money is strongly destabilizing, whereas fluctuations in industrial production and the real exchange rate are largely insignificant. Government spending and exposure to external shocks, including import prices and geopolitical risks, further amplify this volatility. The observed negative trend over time reflects gradual improvements owing to policy reforms. Policy recommendations emphasize the establishment of genuinely independent and credible monetary institutions, enhancing coordination with fiscal policy, improving communication strategies, and strengthening risk management.