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Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment

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Author Info
Jan Libich ()
Andrew Hughes Hallett
Petr Stehlik

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Abstract

Monetary and fiscal policies interact in many ways. Recently, the stance of fiscal policy in a number of countries (including the EU and the US) has raised concerns about risks for the outcomes of monetary policy. Our paper first shows that these concerns are justified since - under an ambitious fiscal policymaker - 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 possible solution the paper proposes a novel asynchronous game theoretic framework that generalizes the standard commitment concept. Most importantly, it allows for concurrent and partial commitment, ie both policies may be committed at the same time, and may do so with varying degrees. It is demonstrated that the undesirable scenario can be prevented if monetary commitment is sufficiently strong relative to fiscal commitment. Interestingly, such strong monetary commitment can not only resist fiscal pressure, but also discipline an ambitious fiscal policymaker and achieve socially desirable outcomes for both policies. We then extend the setting to the European monetary union case with a common central bank and many heterogeneous fiscal policymakers and show that these findings carry over. The policy implication therefore follows: by more explicitly committing to a numerical (long-run) inflation target, the ECB, the Fed, and others would not only ensure their credibility, but also indirectly induce a reduction in the size of the budget deficit and debt. The paper concludes by showing that all our predictions are empirically supported.

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Paper provided by Australian National University, Centre for Applied Macroeconomic Analysis in its series CAMA Working Papers with number 2007-21.

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Length: 39 pages
Date of creation: Oct 2007
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Handle: RePEc:acb:camaaa:2007-21

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Find related papers by JEL classification:
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization
C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games

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References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Andrew Hughes Hallet & Jan Libich & Petr Stehlik, 2008. "Welfare Improving Coordination Of Fiscal And Monetary Policy," CAMA Working Papers 2008-04, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
  2. Andrew Hughes Hallett & Jan Libich & Petr Stehlik, 2007. "Rogoff Revisited: The Conservative Central Banker Proposition Under Active Fiscal Policies," CAMA Working Papers 2007-20, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
    Other versions:
  3. Andrew Hughes Hallett, 2008. "Sustainable fiscal policies and budgetary risk under alternative monetary policy arrangements," Economic Change and Restructuring, Springer, vol. 41(1), pages 1-28, March. [Downloadable!] (restricted)
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