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Policy Biases when the Monetary and Fiscal Authorities have Different Objectives

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  • Herman Bennett
  • Norman Loayza

Abstract

Central bank independence has contributed to achieve price stability and fiscal discipline for many countries. This is an accepted first-generation reform of fiscal and monetary policy. The question this paper asks is whether a second-generation reform consisting of institutional incentives for domestic policy coordination could be beneficial. The paper presents a game-theoretic model where the fiscal and monetary authorities interact to stabilize the economy. These authorities are different in that they have dissimilar preferences with respect to output and inflation gaps and control different policy instruments. Modeled as Nash or Stackelberg equilibria, the solution under lack of policy coordination implies that an increase in the preference divergence between the monetary and fiscal authorities leads to, ceteris paribus, larger public deficits (the fiscal authority's policy instrument) and higher interest rates (the central bank's instrument). The empirical section of the paper tests this conclusion on a pooled sample of 19 industrial countries with annual information for the period 1970-94. Controlling for other shocks and economic conditions, the estimation results support the main conclusion of the theoretical section. The policy implication of the paper is that, without prejudice to the gains from central bank independence, institutional arrangements that allow for coordination both at the level of setting objectives and at the level of policy implementation can alleviate the biases that move the economy to sub-optimally higher fiscal deficits and real interest rates.

Suggested Citation

  • Herman Bennett & Norman Loayza, 2000. "Policy Biases when the Monetary and Fiscal Authorities have Different Objectives," Working Papers Central Bank of Chile 66, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:66
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    References listed on IDEAS

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    1. William D. Nordhaus, 1994. "Policy games: Coordination and Independece in Monetary and Fiscal Policies," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 139-216.
    2. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    3. Cukierman, Alex & Webb, Steven B & Neyapti, Bilin, 1992. "Measuring the Independence of Central Banks and Its Effect on Policy Outcomes," World Bank Economic Review, World Bank Group, vol. 6(3), pages 353-398, September.
    4. Cukierman Alex, 1992. "Central Bank Strategy, Credibility, And Independance: Theory And Evidence," Journal des Economistes et des Etudes Humaines, De Gruyter, vol. 3(4), pages 1-10, December.
    5. Loewy, Michael B, 1988. "Reaganomics and Reputation Revisited," Economic Inquiry, Western Economic Association International, vol. 26(2), pages 253-263, April.
    6. Walsh, Carl E., 1993. "Central bank strategies, credibility, and independence : A review essay," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 287-302, November.
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    Cited by:

    1. Mehmet BÖLÜKBAÞ, 2016. "The Effects of Economic Policies in Turkey: An Application for the Period After 2000," Journal of Social and Administrative Sciences, KSP Journals, vol. 3(4), pages 315-322, December.
    2. Irena Woroniecka-Leciejewicz, 2015. "Equilibrium strategies in a fiscal-monetary game. A simulation analysis," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 2, pages 75-100.
    3. Luis Felipe Céspedes C. & Rodrigo Valdés P., 2006. "Central Bank Autonomy: The Chilean Experience," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 9(1), pages 25-47, April.
    4. Luis Felipe Céspedes & Rodrigo Valdés, 2006. "Autonomía de Bancos Centrales: La Experiencia Chilena," Working Papers Central Bank of Chile 358, Central Bank of Chile.
    5. Md. Habibur Rahman, 2009. "Relative Effectiveness of Monetary and Fiscal Policies on Output Growth in Bangladesh: A VAR Approach," Working Papers id:2100, eSocialSciences.
    6. Kamal, Mona, 2010. "التحقق من أثر التنسيق بين السياستين المالية والنقدية على الأهداف الاقتصادية باستخدام نموذج قياسي
      [The Assessment of the Impact of the Coordination between Fiscal and Monetary Policies on Economic O
      ," MPRA Paper 26670, University Library of Munich, Germany.

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