Working Paper: CEPR ID: DP2324
Authors: Roel Beetsma; A. Lans Bovenberg
Abstract: This paper explores the interaction between centralized monetary policy and decentralized fiscal policy in a monetary union. Discretionary monetary policy suffers from a failure to commit. Moreover, decentralized fiscal policymakers impose externalities on each other through the influence of their debt policies on the common monetary policy. These imperfections can be alleviated by adopting state-contingent inflation targets (to combat the monetary policy commitment problem) and shock-contingent debt targets (to internalize the externalities due to decentralized fiscal policy).
Keywords: discretionary monetary policy; decentralized fiscal policy; monetary union; inflation targets; debt targets
JEL Codes: E52; E58; E61; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| discretionary monetary policy suffers from a failure to commit (E60) | suboptimal outcomes (I14) |
| decentralized fiscal policies create externalities (H39) | negatively impact common monetary policy (E49) |
| state-contingent inflation targets can address the commitment problem in monetary policy (E61) | mitigate suboptimal outcomes (E71) |
| shock-contingent debt targets can internalize externalities of decentralized fiscal policies (E61) | improve common monetary policy (E52) |
| high initial debt levels (F34) | strategically accumulate public debt to influence central bank towards expansionary monetary policy (E62) |
| strategically accumulate public debt to influence central bank towards expansionary monetary policy (E62) | impose negative externalities on other countries (F69) |
| impose negative externalities on other countries (F69) | result in welfare losses (D69) |
| country-specific debt targets + inflation targets (H63) | achieve second-best equilibrium (D51) |