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Strategic Interactions between an Independent Central Bank and a Myopic Government with Government Debt

  • Stehn, Sven Jari
  • Vines, David

We analyse optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model. First, when lump-sum taxes are available and public debt is absent, we show that a Nash game results in too much government spending and excessively high interest rates, while fiscal leadership reinstates the cooperative outcome under discretion. Second, we show that this familiar result breaks down when lump-sum taxes are unavailable. With government debt, the Nash equilibrium still entails too much public spending but leads to lower interest rates than the cooperative policy, because debt has to be adjusted back to its pre-shock level to ensure time consistency. A setup of fiscal leadership does not avoid this socially costly outcome. Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially, while appointing a conservative central bank is less effective.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6913.

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Date of creation: Jul 2008
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Handle: RePEc:cpr:ceprdp:6913
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  1. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
  2. Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages C93-108, March.
  3. Maurice Obstfeld, 1989. "Dynamic Seigniorage Theory: An Exploration," NBER Working Papers 2869, National Bureau of Economic Research, Inc.
  4. Simon Wren-Lewis & Campbell Leith, 2007. "Fiscal Sustainability in a New Keynesian Model," Economics Series Working Papers 310, University of Oxford, Department of Economics.
  5. Avinash Dixit & Luisa Lambertini, 2003. "Interactions of Commitment and Discretion in Monetary and Fiscal Policies," American Economic Review, American Economic Association, vol. 93(5), pages 1522-1542, December.
  6. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers 4334, C.E.P.R. Discussion Papers.
  7. 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.
  8. Tatiana Kirsanova & Simon Wren-Lewis, 2007. "Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," Discussion Papers 0705, Exeter University, Department of Economics.
  9. Luisa Lambertini, 2004. "Monetary-Fiscal Interactions with a Conservative Central Bank," 2004 Meeting Papers 627, Society for Economic Dynamics.
  10. repec:sae:niesru:v:164:y::i:1:p:100-109 is not listed on IDEAS
  11. 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.
  12. Eggertsson, Gauti B., 2006. "The Deflation Bias and Committing to Being Irresponsible," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 283-321, March.
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