Beyond The Design Of Monetary Policy Alone: Fiscal Commitment, Macro Coordination, And Structural Adjustment

Analysis of the design of institutions to counteract failures of monetary commitment has largely proceeded in a vacuum. It has ignored similar commitment problems in fiscal policy and in structural adjustment; and it has ignored coordination problems between monetary and fiscal policy. Optimal second-best monetary design will of course depend on the extent to which these other failures can also be solved. The Paper develops a model in which the extent of structural adjustment thus far accomplished influences the ability to raise non-distortionary tax revenue. A poor structural inheritance implies both a low current output, reduced by severe tax distortions, and the need to resort to high levels of the inflation tax. Low output and high inflation both reflect a poor structural inheritance, which can be improved by investing scarce current resources in structural improvements for the future. The chosen rate of adjustment is derived in various regimes. This framework leads naturally to a discussion of the appropriate form of delegated monetary independence, its relation to the ability to make fiscal and adjustment commitments, and the possible role that EMU may play. Clearly, monetary commitment alone cannot accomplish the first best, and might actually make things worse. The analysis offers insights about other forms of external conditionality that might be welfare-improving for transition economies hoping to accede to EMU. The analysis also highlights the danger of believing that a slimline IMF could confine itself to monetary and fiscal policy without worrying about structural adjustment.