Working Paper: CEPR ID: DP7741
Authors: Klaus Adam; Roberto M. Billi
Abstract: We study interactions between monetary policy, which sets nominal interest rates, and fiscal policy, which levies distortionary income taxes to finance public goods, in a standard, sticky-price economy with monopolistic competition. Policymakers' inability to commit in advance to future policies gives rise to excessive inflation and excessive public spending, resulting in welfare losses equivalent to several percent of consumption each period. We show how appointing a conservative monetary authority, which dislikes inflation more than society does, can considerably reduce these welfare losse and that optimally the monetary authority is predominatly concerned about inflation. Full conservatism, i.e., exclusive concern about inflation, entirely eliminates the welfare losses from discretionary monetary and fiscal policymaking, provided monetary policy is determined after fiscal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with fiscal policy or before fiscal policy each period.
Keywords: discretion; Nash and Stackelberg equilibria; policy biases; sequential noncooperative policy games
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 |
|---|---|
| Discretionary fiscal policy (E62) | public spending bias (H50) |
| Discretionary monetary policy (E60) | inflationary bias (E31) |
| Discretionary monetary policy (E60) | steady-state inflation rate (E31) |
| Conservative monetary authority (E58) | welfare losses (D69) |
| Degree of monetary conservatism (E62) | welfare outcomes (I38) |