Monetary and Fiscal Policy Interaction With Various Degrees of Commitment1

Well before the global financial crisis, the stance of fiscal policy in a number of countries had raised concerns about risks for the outcomes of monetary policy. To provide some insights this paper examines the fiscal-monetary interactions in a novel game theory framework with asynchronous timing of moves. It generalizes the standard commitment concept of Stackelberg leadership by making it dynamic: it allows policies to be committed or rigid for different periods of time. We find that the (active fiscal, passive monetary) policy equilibrium characterized by socially inferior medium-term monetary outcomes due to fiscal spillovers can occur, and this is more likely in a monetary union due to free-riding. The bad news is that, unlike under static commitments, this may happen even if monetary policy acts as the leader for longer periods than fiscal policy. The good news is that appropriate institutional design of monetary policy may not only help the central bank resist fiscal pressure, but also discipline ambitious governments. Strong monetary commitment may therefore induce a reduction in the average size of the budget deficit and debt, moving the economy to the (passive fiscal, active monetary) policy equilibrium. The implication is that monetary policy in the United States, Switzerland, Japan, Eurozone, and other countries should be committed more explicitly to a numerical inflation target, and that this can improve the medium to long-term outcomes of both monetary and fiscal policy.