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Fiscal Rigidity In A Monetary Union: The Calvo Timing And Beyond

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  • Jan Libich

    ()

  • Petr Stehlik

    ()

Abstract

The paper analyzes the interactions between monetary and fiscal policies. Its emphasis is on a monetary union; one in which (some of) the governments are excessively ambitious. In contrast to conventional games, our novel game theoretic framework allows for stochastic timing of policy actions. The fact that moves occur with some ex-ante probability distribution (rather than certainty every period) enables us to model various degrees of fiscal rigidity and indiscipline that are heterogeneous across the member countries. We examine a number of specifications in discrete and continuous time, such as the widely-used Calvo (1983) timing, as well as a fully general probability distribution of the timing of policy actions. We derive the necessary and sufficient degree of monetary commitment that eliminates socially inferior (subgame perfect Nash) equilibria. This degree is shown to be increasing in (i) the degree of fiscal rigidity of each member country, (ii) their relative economic size, (iii) the structure of the economy (that determines eg inflation and output variability costs), and (iv) the degree of the central banker's impatience. Interestingly, such a strong monetary commitment - interpretable as a sufficiently explicit numerical inflation target - does not only ensure high credibility of the central bank, but it also indirectly "disciplines" the fiscal policymaker(s). As such, it leads to an improvement in monetary-fiscal policy cooperation and outcomes of both policies. We conclude by calibrating the model with European Monetary Union data. This exercise aims at providing some quantitative predictions regarding the required explicitness of the European Central Bank's commitment to an inflation target.

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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2008-22.

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Length: 23 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:een:camaaa:2008-22

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  1. Roger Lagunoff & Akihiko Matsu, . ""Asynchronous Choice in Repeated Coordination Games''," CARESS Working Papres 96-10, University of Pennsylvania Center for Analytic Research and Economics in the Social Sciences.
  2. Mats Persson & Torsten Persson & Lars E. O. Svensson, 2006. "Time Consistency of Fiscal and Monetary Policy: A Solution," Econometrica, Econometric Society, vol. 74(1), pages 193-212, 01.
  3. Jan Libich & Andrew Hughes Hallett & Petr Stehlik, 2007. "Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment," CAMA Working Papers 2007-21, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  4. Faust, Jon & Svensson, Lars E O, 1998. "Transparency and Credibility: Monetary Policy with Unobservable Goals," CEPR Discussion Papers 1852, C.E.P.R. Discussion Papers.
  5. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  6. Richard C. Barnett, 2001. "Inflation, taxes, and the coordination of monetary and fiscal policy by use of a game of chicken," Canadian Journal of Economics, Canadian Economics Association, vol. 34(1), pages 82-99, February.
  7. Quan Wen, 2002. "Repeated Games with Asynchronous Moves," Vanderbilt University Department of Economics Working Papers 0204, Vanderbilt University Department of Economics.
  8. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
  9. Andrew Hughes Hallett & Jan Libich, 2007. "Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility," Open Economies Review, Springer, vol. 18(5), pages 559-576, November.
  10. Joydeep Bhattacharya & Joseph H. Haslag, 1999. "Monetary policy arithmetic: some recent contributions," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, issue Q III, pages 26-36.
  11. Gauti B. Eggertsson & Michael Woodford, 2006. "Optimal Monetary and Fiscal Policy in a Liquidity Trap," NBER Chapters, in: NBER International Seminar on Macroeconomics 2004, pages 75-144 National Bureau of Economic Research, Inc.
  12. Jan Libich, 2006. "An Explicit Inflation Target As A Commitment Device," CAMA Working Papers 2006-22, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  13. J. Tirole & E. Maskin, 1982. "A Theory of Dynamic Oligopoly, I: Overview and Quantity Competition with Large-Fixed Costs," Working papers 320, Massachusetts Institute of Technology (MIT), Department of Economics.
  14. Robert A. Mundell, 1962. "The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability," IMF Staff Papers, Palgrave Macmillan, vol. 9(1), pages 70-79, March.
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Cited by:
  1. Suren Basov & Jan Libich & Petr Stehlík, 2010. "Stochastic Timing, Uniqueness, and Efficiency in Games," Working Papers 2010.01, School of Economics, La Trobe University.

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