Monetary and Fiscal Policy Interaction with Various Degrees and Types of Commitment

Andrew Hughes Hallett (), Jan Libich () and Petr Stehlík

No 6586, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Monetary and Fiscal policies interact in many ways. Recently the stance of fiscal policy in a number of countries has raised concerns about the risks for the outcomes of monetary policy. This paper first shows that these concerns are justified since, under ambitious fiscal policy makers, inflation bias and lack of monetary policy credibility may obtain in equilibrium even if the central banker is fully independent, patient and responsible. To reach a solution, the paper proposes an asynchronous game framework that generalises the standard commitment analysis. It allows concurrent and partial commitment; both policies may be committed at the same time for varying degrees or different periods. It is demonstrated that these undesirable outcomes can be prevented if monetary commitment is sufficiently strong relative to fiscal commitment. Interestingly, monetary commitment can not only resist fiscal pressure, but also discipline an ambitious fiscal policy maker to achieve socially desirable outcomes for both policies. We extend the setting to the European monetary union case with a common central bank and many fiscal policy makers, to show that these results carry over. The implication therefore is: by explicitly committing to a long run inflation target, the central bank can not only ensure its credibility, but also indirectly induce more disciplined fiscal policies. The paper shows that these predictions are broadly supported empirically.

Keywords: asynchronous moves; Battle of sexes; commitment; Game of chicken; inflation targeting; monetary-fiscal interactions (search for similar items in EconPapers)
JEL-codes: C73 E61 E63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2007-11
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Working Paper: MONETARY AND FISCAL POLICY INTERACTION WITH VARIOUS DEGREES AND TYPES OF COMMITMENT (2007)
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