Monetary and Fiscal Policy Interaction With Various Degrees and Types of Commitment

Monetary and …scal policies interact in many ways. Recently, the stance of …scal policy in a number of countries (including the EU and US) has raised concerns about risks for the outcomes of monetary policy. Our paper …rst shows that these concerns are justi…ed since under an ‘ambitious’…scal policymaker in‡ation 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 possible solution the paper proposes a novel asynchronous game theoretic framework that generalizes the standard commitment concept; most importantly it allows for concurrent commitment of both policies and varying degrees of their commitment. It is demonstrated that the undesirable scenario can be prevented if monetary commitment is su¢ ciently strong relative to …scal commitment. Interestingly, such strong monetary commitment can not only resist …scal pressure, but also ‘discipline’an ambitious …scal policymaker and achieve socially desirable outcomes for both policies. We then extend the setting to the European monetary union case with a common central bank and many heterogeneous …scal policymakers and show that these …ndings carry over. The policy implication therefore follows: by more explicitly committing to a numerical (long-run) in‡ation target, the ECB, the Fed, and others would not only ensure their credibility, but also indirectly induce a reduction in the size of the budget de…cit and debt. The paper concludes by showing that all our predictions are empirically supported. Keywords: commitment, asynchronous/alternating moves, monetary vs …scal policy interaction, Game of chicken, Battle of sexes, in‡ation targeting JEL classi…cation: E61, E63, C73 We are grateful to Don Brash, the Governor of the Reserve Bank of New Zealand during 19882002, for valuable views and for his case study of Section 9.2.1. We would also like to thank Iris Claus, Damien Eldridge, Frank Hespeler, Je¤ Sheen, Lawrence Uren, and the participants of the 24th Australasian Economic Theory Workshop, 12th Australasian Macroeconomics Workshop, the Central European Program in Economic Theory workshop, and the Fiscal Policy Frameworks conference for useful suggestions and comments. All errors and omissions are our own responsibility. Corresponding author: La Trobe University, School of Business, Melbourne, Victoria, 3086, Australia. Phone: +61 3 94792754, Email: [email protected]. School of Public Policy, MS 3C6, George Mason University Fairfax, VA 22030, USA, phone: 703993-9123, fax: 703-993-2284, email: [email protected]. University of West Bohemia, Univerzitni 22, Plzen, 30614, Czech Republic. Phone: (+420) 777 846 682, Fax: (+420) 377 632 602, Email: [email protected].