Monetary and Fiscal Policy Interactions: The Role of the Quality of Institutions in a Dynamic Environment

Ourania Dimakou
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Ourania Dimakou: Department of Economics, Mathematics & Statistics, Birkbeck

No 607, Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics

Abstract: This paper analyses the interaction between fiscal and monetary policy using the original Barro and Gordon (1983) model extended to include fiscal policy, dynamics and the level of institutional quality, measured as bureaucratic corruption. It is found that delegating monetary policy to an independent central bank (i.e. not fiscally dominated) the second best solution of the model is achievable only if there is no bureaucratic corruption. Otherwise, when institutional quality is not optimal, unless a less conservative than the government, regarding output considerations, independent central bank is delegated, the second best is not restored. The government has the incentive to increase debt strategically in an attempt to increase second period inflation. This result is augmented by the quality of institutions and poses difficulties on the achievement of both price stability and a balanced debt process. Quality of institutions, hence, can provide an explanation for the poorer inflation performance, due to debt boosts, of countries with lower institutional quality despite the introduction of central bank independence.

Keywords: Monetary and Fiscal policy; time-inconsistency; independent central bank; corruption (search for similar items in EconPapers)
JEL-codes: E58 E61 E63 (search for similar items in EconPapers)
Date: 2006-07
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-pbe
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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https://eprints.bbk.ac.uk/id/eprint/26934 First version, 2006 (application/pdf)

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