Working Paper: CEPR ID: DP5740
Authors: Klaus Adam; Roberto M. Billi
Abstract: Does an inflation conservative central bank à la Rogoff (1985) remain desirable in a setting with endogenous fiscal policy? To provide an answer we study monetary and fiscal policy games without commitment in a dynamic stochastic sticky price economy with monopolistic distortions. Monetary policy determines nominal interest rates and fiscal policy provides public goods generating private utility. We find that lack of fiscal commitment gives rise to excessive public spending. The optimal inflation rate internalizing this distortion is positive, but lack of monetary commitment robustly generates too much inflation. A conservative monetary authority thus remains desirable. Exclusive focus on inflation by the central bank recoups large part - in some cases all - of the steady state welfare losses associated with lack of monetary and fiscal commitment. An inflation conservative central bank tends to improve also the conduct of stabilization policy.
Keywords: conservative monetary policy; discretionary policy; sequential non-cooperative policy games; time-consistent policy
JEL Codes: E52; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lack of fiscal commitment (E62) | excessive public spending (H72) |
| excessive public spending (H72) | welfare losses (D69) |
| optimal inflation rate (E31) | negative effects of fiscal overspending (E62) |
| lack of monetary commitment (E49) | inflation bias (E31) |
| inflation bias (E31) | inflation rates exceed socially optimal levels (E31) |
| conservative monetary authority (E58) | welfare losses (D69) |
| optimal inflation rate (E31) | inflation bias (E31) |