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

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Author Info
Hughes Hallett, Andrew
Libich, Jan
Stehlík, Petr

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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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6586.

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Date of creation: Nov 2007
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Handle: RePEc:cpr:ceprdp:6586

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Related research
Keywords: asynchronous moves; Battle of sexes; commitment; Game of chicken; inflation targeting; monetary-fiscal interactions;

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Find related papers by JEL classification:
C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
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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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 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)
  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 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!]
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