Working Paper: CEPR ID: DP6913
Authors: Sven Jari Stehn; David Vines
Abstract: We analyse optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model. First, when lump-sum taxes are available and public debt is absent, we show that a Nash game results in too much government spending and excessively high interest rates, while fiscal leadership reinstates the cooperative outcome under discretion. Second, we show that this familiar result breaks down when lump-sum taxes are unavailable. With government debt, the Nash equilibrium still entails too much public spending but leads to lower interest rates than the cooperative policy, because debt has to be adjusted back to its pre-shock level to ensure time consistency. A setup of fiscal leadership does not avoid this socially costly outcome. Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially, while appointing a conservative central bank is less effective.
Keywords: noncooperative games; optimal fiscal policy; optimal monetary policy; policy myopia; stabilisation bias
JEL Codes: E52; E60; E61; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Nash game (C72) | high interest rates (E43) |
| excessive government spending (H72) | higher interest rate (E43) |
| higher interest rate (E43) | further monetary tightening (E49) |
| fiscal leadership (E62) | cooperative equilibrium (C71) |
| Nash equilibrium (C72) | lower interest rates (E43) |
| myopic government's insufficient contribution to debt adjustment (H63) | active monetary policy (E63) |
| debt penalty on myopic government (H74) | welfare outcomes (I38) |
| appointing a conservative central bank (E58) | effectiveness in addressing issues (I24) |