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Fiscal Constraints on Central Bank Independence and Price Stability

  • Canzoneri, Matthew B
  • Diba, Behzad

We use a new theory of price determination – developed by Woodford, Simms and others – to characterize central bank independence and price stability. If fiscal policy guarantees that the price level is determined independently of government’s present value budget constraint, we can say that the central bank is operating in a monetary dominant regime; it has the ‘functional independence’ necessary to control the price level independently of the dictates of fiscal solvency (if it so chooses), and it can be held accountable for price stability (if that is its mandate). If fiscal policy does not allow this, we say the central bank is operating in a fiscal dominant regime. Numerical exercises suggest that price stability may be beyond the control of the central bank in such a regime. We show that strict enforcement of the Maastricht Treaty’s deficit criterion would ensure a monetary dominant regime.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1463.

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Date of creation: Sep 1996
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Handle: RePEc:cpr:ceprdp:1463
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