Strategic Interactions between an Independent Central Bank and a Myopic Government with Government Debt

Sven Jari Stehn () and David Vines

No 6913, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We analyse optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model. First, when lump-sum taxes are available and public debt is absent, we show that a Nash game results in too much government spending and excessively high interest rates, while fiscal leadership reinstates the cooperative outcome under discretion. Second, we show that this familiar result breaks down when lump-sum taxes are unavailable. With government debt, the Nash equilibrium still entails too much public spending but leads to lower interest rates than the cooperative policy, because debt has to be adjusted back to its pre-shock level to ensure time consistency. A setup of fiscal leadership does not avoid this socially costly outcome. Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially, while appointing a conservative central bank is less effective.

Keywords: Non-cooperative games; Optimal Fiscal Policy; Optimal Monetary Policy; Policy Myopia; Stabilisation Bias (search for similar items in EconPapers)
JEL-codes: E52 E60 E61 E63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac and nep-mon
Date: Written 2008-07

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