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

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Author Info
Ourania Dimakou (Department of Economics, Mathematics & Statistics, Birkbeck)
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.

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File URL: http://www.ems.bbk.ac.uk/research/wp/PDF/BWPEF0607.pdf
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File Function: First version, 2006
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Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0607.

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Date of creation: Jul 2006
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Handle: RePEc:bbk:bbkefp:0607

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Related research
Keywords: Monetary and Fiscal policy; time-inconsistency; independent central bank; corruption;

Find related papers by JEL classification:
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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

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  1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121. [Downloadable!] (restricted)
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  2. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November. [Downloadable!] (restricted)
  3. Huang, Haizhou & Wei, Shang-Jin, 2005. "Monetary Policies for Developing Countries: The Role of Institutional Quality," CEPR Discussion Papers 4911, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Mauro, Paolo, 1995. "Corruption and Growth," The Quarterly Journal of Economics, MIT Press, vol. 110(3), pages 681-712, August. [Downloadable!] (restricted)
  5. Canzoneri, Matthew B, 1985. "Monetary Policy Games and the Role of Private Information," American Economic Review, American Economic Association, vol. 75(5), pages 1056-70, December. [Downloadable!] (restricted)
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  6. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall. [Downloadable!]
  7. Beetsma,Roel M.W.J. & Bovenberg,A. Lans, 1995. "The role of public debt in the game of double chicken," Research Memoranda 025, Maastricht : METEOR, Maastricht Research School of Economics of Technology and Organization. [Downloadable!]
  8. Obstfeld, Maurice, 1991. "Dynamic Seigniorage Theory: An Exploration," CEPR Discussion Papers 519, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Jensen, Henrik, 1994. "Loss of monetary discretion in a simple dynamic policy game," Journal of Economic Dynamics and Control, Elsevier, vol. 18(3-4), pages 763-779. [Downloadable!] (restricted)
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  10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
  11. Beetsma, Roel M. W. J. & Bovenberg, A. Lans, 1997. "Central bank independence and public debt policy," Journal of Economic Dynamics and Control, Elsevier, vol. 21(4-5), pages 873-894, May. [Downloadable!] (restricted)
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