Working Paper: CEPR ID: DP5043
Authors: Andrew Hughes Hallett
Abstract: This paper attempts to reconcile the need for flexibility in fiscal policy, with the need for credibility and consistency in monetary policies. The idea is to generate fewer conflicts between policies but greater discipline within them. We assume an independent central bank and restraints on the use of national fiscal policies. Using a theoretical model, we examine the consequences of assigning leadership to fiscal or monetary policies to exploit the implicit (rule based) coordination available under standard transmission mechanisms, but where priorities and targets differ between policy makers. This works best with fiscal leadership: we introduce a debt rule (with hard or soft targets) to precommit fiscal policies over the longer term, but use monetary independence to guarantee credibility and discipline in the short run stabilization policies. Compared to the uncoordinated solution now operating in Europe, inflation biases are lower and debt repayments higher for no loss in output volatility. That corresponds to the experience of the UK, our benchmark case, whose empirical reaction functions show fiscal leadership. Across ten OECD countries, these gains are estimated to be worth 2%-4% of GDP.
Keywords: debt rule; institutional coordination; soft targets; Stackelberg leadership
JEL Codes: E52; E61; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal leadership (E62) | Lower inflation biases (E31) |
| Fiscal leadership (E62) | Higher debt repayments (F34) |
| Fiscal leadership (E62) | Output volatility (C69) |
| Credibility of independent monetary authority (E58) | Better coordination of policies (F42) |
| Fiscal leadership (E62) | Economic stability (E60) |
| Debt rules (H63) | Better fiscal discipline and coordination (E62) |
| Soft targets for debt (F34) | Enhanced compliance (H26) |
| Fiscal policy leads (E62) | Better economic results (P17) |