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Central bank independence and the monetary instrument problem

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  • Niemann, S
  • Pichler, P
  • Sorger, G

Abstract

We study the monetary instrument problem in a model of optimal discretionary fiscal and monetary policy. The policy problem is cast as a dynamic game between the central bank, the fiscal authority, and the private sector. We show that, as long as there is a conflict of interest between the two policy-makers, the central bank's monetary instrument choice critically affects the Markov-perfect Nash equilibrium of this game. Focusing on a scenario where the fiscal authority is impatient relative to the monetary authority, we show that the equilibrium allocation is typically characterized by a public spending bias if the central bank uses the nominal money supply as its instrument. If it uses instead the nominal interest rate, the central bank can prevent distortions due to fiscal impatience and implement the same equilibrium allocation that would obtain under cooperation of two benevolent policy authorities. Despite this property, the welfare-maximizing choice of instrument depends on the economic environment under consideration. In particular, the money growth instrument is to be preferred whenever fiscal impatience has positive welfare effects, which is easily possible under lack of commitment.

Suggested Citation

  • Niemann, S & Pichler, P & Sorger, G, 2010. "Central bank independence and the monetary instrument problem," Economics Discussion Papers 2902, University of Essex, Department of Economics.
  • Handle: RePEc:esx:essedp:2902
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    Cited by:

    1. Masciandaro, Donato & Romelli, Davide, 2015. "Ups and downs of central bank independence from the Great Inflation to the Great Recession: theory, institutions and empirics," Financial History Review, Cambridge University Press, vol. 22(03), pages 259-289, December.
    2. Donato Masciandaro & Davide Romelli, 2015. "Ups and Downs. Central Bank Independence from the Great Inflation to the Great Recession: Theory, Institutions and Empirics," BAFFI CAREFIN Working Papers 1503, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    3. Martin, Fernando M., 2015. "Debt, inflation and central bank independence," European Economic Review, Elsevier, vol. 79(C), pages 129-150.
    4. Pichler, Paul, 2011. "Solving the multi-country Real Business Cycle model using a monomial rule Galerkin method," Journal of Economic Dynamics and Control, Elsevier, vol. 35(2), pages 240-251, February.
    5. Donato Masciandaro & Davide Romelli, 2018. "To Be or not to Be a Euro Country? The Behavioural Political Economics of Currency Unions," BAFFI CAREFIN Working Papers 1883, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    6. repec:kap:pubcho:v:177:y:2018:i:3:d:10.1007_s11127-018-0584-7 is not listed on IDEAS
    7. Miller, David S., 2016. "Commitment versus discretion in a political economy model of fiscal and monetary policy interaction," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 17-29.

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