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Commitment versus Discretion in a Political Economy Model of Fiscal and Monetary Policy Interaction

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  • David Miller

    (Federal Reserve Board)

Abstract

Price commitment results in lower welfare. I explore the consequences of price commitment by pairing an independent monetary authority issuing nominal bonds with a fiscal authority whose endogenous spending decisions are determined by a political economy model. Without price commitment, nominal bonds are backed by a new form of endogenous commitment that overcomes time inconsistency to make tax smoothing possible. With price commitment, nominal bonds will be used for both tax smoothing and wasteful spending. Price commitment eliminates monetary control over fiscal decisions. I show that the combination observed in advanced economies of a politically distorted fiscal authority and an independent monetary authority with nominal bonds and without price commitment is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest welfare.

Suggested Citation

  • David Miller, 2014. "Commitment versus Discretion in a Political Economy Model of Fiscal and Monetary Policy Interaction," 2014 Meeting Papers 80, Society for Economic Dynamics.
  • Handle: RePEc:red:sed014:80
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    References listed on IDEAS

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    1. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
    2. Marco Battaglini, 2009. "On the Case for a Balanced Budget Amendment to the U.S. Constitution," 2009 Meeting Papers 131, Society for Economic Dynamics.
    3. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 519-539, August.
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