Working Paper: CEPR ID: DP2851
Authors: Roel Beetsma; A. Lans Bovenberg
Abstract: The combination of discretionary monetary policy, labour-market distortions and nominal wage rigidity yields an inflation bias as monetary policy tries to exploit nominal wage contracts to address labour-market distortions. Although an inflation target eliminates this inflation bias, it creates a conflict between monetary policy and discretionary fiscal policy if fiscal policy is set at a higher frequency than nominal wages are. To avoid the associated excessive accumulation of public debt, ceilings on public debt are called for. If countries differ substantially in terms of structural distortions or economic shocks, country-specific debt targets must complement uniform debt ceilings in order to prevent decentralized fiscal authorities from employing debt policy strategically.
Keywords: debt targets; decentralized fiscal policy; discretionary monetary policy; inflation targets; monetary union; wage rigidity
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 + labor market distortions + nominal wage rigidity (E69) | inflation bias (E31) |
| inflation target (E31) | eliminates inflation bias (E31) |
| inflation target (E31) | conflict between monetary and discretionary fiscal policies (E62) |
| lack of commitment in monetary and fiscal policymaking (E60) | wasteful strategic interactions (C72) |
| lack of commitment in monetary and fiscal policymaking (E60) | strategic debt accumulation (H63) |
| country-specific debt targets (H63) | prevent decentralized fiscal authorities from strategically employing debt policy (E62) |
| commitment to not engage in strategic debt policies (F38) | better outcomes for all countries (O57) |
| ex ante coordination through inflation and debt targets (E61) | alleviate inflation bias (E31) |
| ex ante coordination through inflation and debt targets (E61) | resolve conflicts among heterogeneous fiscal authorities (H77) |
| ex post coordination may not always be beneficial (E61) | exacerbate conflicts between monetary and fiscal policy (E63) |