Working Paper: CEPR ID: DP6586
Authors: Jan Libich; Andrew Hughes Hallett; Petr Stehlik
Abstract: Monetary and Fiscal policies interact in many ways. Recently the stance of fiscal policy in a number of countries has raised concerns about the risks for the outcomes of monetary policy. This paper first shows that these concerns are justified since, under ambitious fiscal policy makers, inflation bias and lack of monetary policy credibility may obtain in equilibrium even if the central banker is fully independent, patient and responsible. To reach a solution, the paper proposes an asynchronous game framework that generalises the standard commitment analysis. It allows concurrent and partial commitment; both policies may be committed at the same time for varying degrees or different periods. It is demonstrated that these undesirable outcomes can be prevented if monetary commitment is sufficiently strong relative to fiscal commitment. Interestingly, monetary commitment can not only resist fiscal pressure, but also discipline an ambitious fiscal policy maker to achieve socially desirable outcomes for both policies. We extend the setting to the European monetary union case with a common central bank and many fiscal policy makers, to show that these results carry over. The implication therefore is: by explicitly committing to a long run inflation target, the central bank can not only ensure its credibility, but also indirectly induce more disciplined fiscal policies. The paper shows that these predictions are broadly supported empirically.
Keywords: asynchronous moves; battle of sexes; commitment; game of chicken; inflation targeting; monetary-fiscal interactions
JEL Codes: C73; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ambitious fiscal policy (E62) | inflation bias (E31) |
| ambitious fiscal policy (E62) | lack of credibility in monetary policy (E52) |
| strong monetary commitment (E49) | resist fiscal pressures (H69) |
| strong monetary commitment (E49) | discipline ambitious fiscal policymaker (E62) |
| strong monetary commitment (E49) | socially desirable outcomes for both policies (D78) |
| strong monetary commitment (E49) | inflation outcomes (E31) |
| strong monetary commitment (E49) | fiscal discipline (E62) |
| monetary policy credibility (E52) | fiscal policies (H30) |