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Central Bank Independence And The Monetary Instrument Problem

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  • STEFAN NIEMANN
  • PAUL PICHLER
  • GERHARD SORGER

Abstract

We study the monetary instrument problem in a model of optimal discretionary fiscal and monetary policy. The policy problem is cast as a dynamic game between the central bank, the fiscal authority, and the private sector. We show that, as long as there is a conflict of interest between the two policy-makers, the central bank's monetary instrument choice critically affects the Markov-perfect Nash equilibrium of this game. Focussing on a scenario where the fiscal authority is impatient relative to the monetary authority, we show that the equilibrium allocation is typically characterized by a public spending bias if the central bank uses the nominal money supply as its instrument. If it uses instead the nominal interest rate, the central bank can prevent distortions due to fiscal impatience and implement the same equilibrium allocation that would obtain under cooperation of two benevolent policy authorities. Despite this property, the welfare-maximizing choice of instrument depends on the economic environment under consideration. In particular, the money growth instrument is to be preferred whenever fiscal impatience has positive welfare effects, which is easily possible under lack of commitment.

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Bibliographic Info

Article provided by Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association in its journal International Economic Review.

Volume (Year): 54 (2013)
Issue (Month): (08)
Pages: 1031-1055

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Handle: RePEc:wly:iecrev:v:54:y:2013:i::p:1031-1055

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  1. Andreas Schabert, 2006. "Central Bank Instruments, Fiscal Policy Regimes, and the Requirements for Equilibrium Determinacy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(4), pages 742-762, October.
  2. Javier Díaz-Giménez & Giorgia Giovannetti & Ramon Marimon & Pedro Teles, 2004. "Nominal debt as a burden on monetary policy," Working Paper Series WP-04-10, Federal Reserve Bank of Chicago.
  3. Robert G. King & Alexander L. Wolman, 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," International Finance Discussion Papers 802, Board of Governors of the Federal Reserve System (U.S.).
  4. Stefan Niemann & Paul Pichler & Gerhard Sorger, 2009. "Inflation dynamics under optimal discretionary fiscal and monetary policies," Economics Discussion Papers 681, University of Essex, Department of Economics.
  5. Martin Ellison & Neil Rankin, 2005. " Optimal Monetary Policy When Lump-Sum Taxes Are Unavailable: A Reconsideration of the Outcomes under Commitment and Discretion," CDMA Conference Paper Series 0501, Centre for Dynamic Macroeconomic Analysis.
  6. Adam, Klaus & Billi, Roberto M., 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," CFS Working Paper Series 2005/16, Center for Financial Studies (CFS).
  7. Jim Malley & Apostolis Philippopoulos & Ulrich Woitek, 2005. "Electoral Uncertainty, Fiscal Policy and Macroeconomic Fluctuations," CESifo Working Paper Series 1593, CESifo Group Munich.
  8. Michael Dotsey & Andreas Hornstein, 2008. "On the implementation of Markov-perfect interest rate and money supply rules: global and local uniqueness," Working Papers 08-30, Federal Reserve Bank of Philadelphia.
  9. Niemann, Stefan, 2011. "Dynamic monetary–fiscal interactions and the role of monetary conservatism," Journal of Monetary Economics, Elsevier, vol. 58(3), pages 234-247.
  10. Fernando M. Martin, 2004. "A Positive Theory of Government Debt," Macroeconomics 0408013, EconWPA, revised 12 Oct 2004.
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Cited by:
  1. Fernando Martin, 2012. "Debt, Inflation and Central Bank Independence," 2012 Meeting Papers 1019, Society for Economic Dynamics.
  2. Pichler, Paul, 2011. "Solving the multi-country Real Business Cycle model using a monomial rule Galerkin method," Journal of Economic Dynamics and Control, Elsevier, vol. 35(2), pages 240-251, February.
  3. Niemann, Stefan & Pichler, Paul, 2011. "Optimal fiscal and monetary policies in the face of rare disasters," European Economic Review, Elsevier, vol. 55(1), pages 75-92, January.

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