Working Paper: CEPR ID: DP251
Authors: Andrew Hughes Hallett; Maria Luisa Petit
Abstract: In many countries two decision-making institutions, the government and the central bank, manage fiscal and monetary policy separately. Such decentralization can lead to a change in the optimal inflation-output trade-off. In fact lack of cooperation can result in a change in the position of the trade-off curve, or a reversal in the slope of this trade-off, or even the total absence of any exploitable trade-off. In this paper the techniques of differential game theory are used to calculate the efficient inflation-output trade-off within a continuous-time econometric model of the Italian economy, in order to examine the differences in the 'policy possibility frontiers' which arise as the result of cooperative and of noncooperative decision-making. The results show that the outcomes obtained in the case of noncooperation are inferior to those under cooperation, and also impose a policy conflict which would not otherwise be present. Moreover the range of policy choices open to the policy-makers is reduced under noncooperation. The results indicate that efficiency gains are not the only reason for coordinating fiscal and monetary policies.
Keywords: fiscal and monetary policy coordination; policy conflict; differential games; continuous-time models; Italy; inflation-output tradeoff
JEL Codes: 133; 311; 321
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Noncooperation (D74) | shift in the inflation-output tradeoff curve (E31) |
| Noncooperation (D74) | efficiency losses (D61) |
| Noncooperation (D74) | policy conflict (D74) |
| Institutional constraints (D02) | policy conflict (D74) |
| Noncooperative decisions (C72) | reduced policy choices (D72) |
| Cooperative framework (P13) | better inflation-output combinations (E31) |
| Cooperation (C71) | desired economic outcomes (L21) |