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Policy Biases when the Monetary and Fiscal Authorities Have Different Objectives

In: Monetary Policy: Rules and Transmission Mechanisms

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Author Info

  • Herman Bennett

    (Harvard University)

  • Norman Loayza

    (Banco Mundial)

Abstract

Central bank independence has contributed to achieve price stability and fiscal discipline for many countries. This is an accepted first-generation reform of fiscal and monetary policy. The question this paper asks is whether a second-generation reform consisting of institutional incentives for domestic policy coordination could be beneficial. The paper presents a game-theoretic model where the fiscal and monetary authorities interact to stabilize the economy. These authorities are different in that they have dissimilar preferences with respect to output and inflation gaps and control different policy instruments. Modeled as Nash or Stackelberg equilibria, the solution under lack of policy coordination implies that an increase in the preference divergence between the monetary and fiscal authorities leads to, ceteris paribus, larger public deficits (the fiscal authority's policy instrument) and higher interest rates (the central bank's instrument). The empirical section of the paper tests this conclusion on a pooled sample of 19 industrial countries with annual information for the period 1970-94. Controlling for other shocks and economic conditions, the estimation results support the main conclusion of the theoretical section. The policy implication of the paper is that, without prejudice to the gains from central bank independence, institutional arrangements that allow for coordination both at the level of setting objectives and at the level of policy implementation can alleviate the biases that move the economy to sub-optimally higher fiscal deficits and real interest rates.

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Bibliographic Info

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This chapter was published in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) Monetary Policy: Rules and Transmission Mechanisms, , chapter 11, pages 299-330, 2002.

This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v04c11pp299-330.

Handle: RePEc:chb:bcchsb:v04c11pp299-330

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References

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  1. Michael Woodford, 1999. "Optimal Monetary Policy Inertia," NBER Working Papers 7261, National Bureau of Economic Research, Inc.
  2. Cukierman, Alex & Webb, Steven B & Neyapti, Bilin, 1992. "Measuring the Independence of Central Banks and Its Effect on Policy Outcomes," World Bank Economic Review, World Bank Group, World Bank Group, vol. 6(3), pages 353-98, September.
  3. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262031981, December.
  4. Walsh, Carl E., 1993. "Central bank strategies, credibility, and independence : A review essay," Journal of Monetary Economics, Elsevier, Elsevier, vol. 32(2), pages 287-302, November.
  5. Loewy, Michael B, 1988. "Reaganomics and Reputation Revisited," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 26(2), pages 253-63, April.
  6. William D. Nordhaus, 1994. "Policy games: Coordination and Independece in Monetary and Fiscal Policies," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 139-216.
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Citations

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Cited by:
  1. Luis Felipe Céspedes C. & Rodrigo Valdés P., 2006. "Central Bank Autonomy: The Chilean Experience," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 9(1), pages 25-47, April.
  2. Luis Felipe Céspedes & Rodrigo Valdés, 2006. "Autonomía de Bancos Centrales: La Experiencia Chilena," Working Papers Central Bank of Chile, Central Bank of Chile 358, Central Bank of Chile.
  3. Kamal, Mona, 2010. "التحقق من أثر التنسيق بين السياستين المالية والنقدية على الأهداف الاقتصادية باستخدام نموذج قياسي
    [The Assessment o
    ," MPRA Paper 26670, University Library of Munich, Germany.

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