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Central Bank Independence And The Monetary Instrument Problem

Listed author(s):
  • STEFAN NIEMANN
  • PAUL PICHLER
  • GERHARD SORGER

We study the monetary instrument problem in a model of optimal discretionary fiscal and monetary policy. The policy problem is cast as a dynamic game between the central bank, the fiscal authority, and the private sector. We show that, as long as there is a conflict of interest between the two policy-makers, the central bank's monetary instrument choice critically affects the Markov-perfect Nash equilibrium of this game. Focusing on a scenario where the fiscal authority is impatient relative to the monetary authority, we show that the equilibrium allocation is typically characterized by a public spending bias if the central bank uses the nominal money supply as its instrument. If it uses instead the nominal interest rate, the central bank can prevent distortions due to fiscal impatience and implement the same equilibrium allocation that would obtain under cooperation of two benevolent policy authorities. Despite this property, the welfare-maximizing choice of instrument depends on the economic environment under consideration. In particular, the money growth instrument is to be preferred whenever fiscal impatience has positive welfare effects, which is easily possible under lack of commitment.

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Article provided by Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association in its journal International Economic Review.

Volume (Year): 54 (2013)
Issue (Month): (08)
Pages: 1031-1055

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Handle: RePEc:wly:iecrev:v:54:y:2013:i::p:1031-1055
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