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Monetary conservatism and fiscal policy

  • Klaus Adam
  • Roberto M. Billi

Does an inflation conservative central bank à la Rogoff (1985) remain desirable in a setting with endogenous fiscal policy? To provide an answer we study monetary and fiscal policy games without commitment in a dynamic stochastic sticky price economy with monopolistic distortions. Monetary policy determines nominal interest rates and fiscal policy provides public goods generating private utility. We find that lack of fiscal commitment gives rise to excessive public spending. The optimal inflation rate internalizing this distortion is positive, but lack of monetary commitment robustly generates too much inflation. A conservative monetary authority thus remains desirable. When fiscal policy is determined before monetary policy each period, the monetary authority should focus exclusively on stabilizing inflation, as this eliminates the steady state biases associated with lack of monetary and fiscal commitment. It also leads to stabilization policy that is close to if not fully optimal.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 07-01.

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Date of creation: 2007
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Handle: RePEc:fip:fedkrw:rwp07-01
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