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Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment

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  • Jan Libich
  • Andrew Hughes Hallett
  • Petr Stehlik

Abstract

Monetary and fiscal policies interact in many ways. Recently, the stance of fiscal policy in a number of countries (including the EU and the US) has raised concerns about risks for the outcomes of monetary policy. Our paper first shows that these concerns are justified since - under an ‘ambitious’ fiscal policymaker - inflation bias and lack of monetary policy credibility may obtain in equilibrium, even if the central banker is fully independent, patient, and ‘responsible’. To reach a possible solution the paper proposes a novel asynchronous game theoretic framework that generalizes the standard commitment concept. Most importantly, it allows for concurrent and partial commitment, ie both policies may be committed at the same time, and may do so with varying degrees. It is demonstrated that the undesirable scenario can be prevented if monetary commitment is sufficiently strong relative to fiscal commitment. Interestingly, such strong monetary commitment can not only resist fiscal pressure, but also ‘discipline’ an ambitious fiscal policymaker and achieve socially desirable outcomes for both policies. We then extend the setting to the European monetary union case with a common central bank and many heterogeneous fiscal policymakers and show that these findings carry over. The policy implication therefore follows: by more explicitly committing to a numerical (long-run) inflation target, the ECB, the Fed, and others would not only ensure their credibility, but also indirectly induce a reduction in the size of the budget deficit and debt. The paper concludes by showing that all our predictions are empirically supported.

Suggested Citation

  • Jan Libich & Andrew Hughes Hallett & Petr Stehlik, 2007. "Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment," CAMA Working Papers 2007-21, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  • Handle: RePEc:een:camaaa:2007-21
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    Cited by:

    1. Andrew Hughes Hallett, 2008. "Sustainable fiscal policies and budgetary risk under alternative monetary policy arrangements," Economic Change and Restructuring, Springer, vol. 41(1), pages 1-28, March.
    2. Andrew Hughes Hallett & Jan Libich & Petr Stehlík, 2011. "Welfare Improving Coordination of Fiscal and Monetary Policy," Czech Economic Review, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, vol. 5(1), pages 007-026, March.
    3. Libich, Jan, 2008. "An explicit inflation target as a commitment device," Journal of Macroeconomics, Elsevier, vol. 30(1), pages 43-68, March.
    4. Jan Libich & Petr Stehlik, 2008. "Fiscal Rigidity In A Monetary Union: The Calvo Timing And Beyond," CAMA Working Papers 2008-22, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    5. Dumitriu, Ramona & Stefanescu, Razvan, 2013. "Provocările politicii monetare [Monetary policy challenges]," MPRA Paper 50261, University Library of Munich, Germany, revised 28 Sep 2013.
    6. Andrew Hughes Hallett, 2008. "Debt targets and fiscal sustainability in an era of monetary independence," International Economics and Economic Policy, Springer, vol. 5(1), pages 165-187, July.
    7. Pasquale Foresti, 2018. "Monetary And Fiscal Policies Interaction In Monetary Unions," Journal of Economic Surveys, Wiley Blackwell, vol. 32(1), pages 226-248, February.
    8. Andrew Hughes Hallett, 2008. "Coordination without Explicit Cooperation: Monetary-Fiscal Interactions in an Era of Demographic Change," European Economy - Economic Papers 2008 - 2015 305, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission.
    9. Andrew Hughes Hallett & Jan Libich & Petr Stehlik, 2009. "Financial instability prevention," CAMA Working Papers 2009-14, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    10. Hughes Hallett, Andrew & Libich, Jan & Stehlík, Petr, 2009. "Rogoff revisited: The conservative central banker proposition under active fiscal policies," Economics Letters, Elsevier, vol. 104(3), pages 140-143, September.
    11. Adam Geršl & Martina Jašová & Jan Zápal, 2014. "Fiscal Councils and Economic Volatility," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 64(3), pages 190-212, June.

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    More about this item

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games

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