Distortionary scal policy and monetary policy goals1

We study interactions between monetary policy, which sets nominal interest rates, and …scal policy, which levies distortionary income taxes to …nance public goods, in a standard, stickyprice economy with monopolistic competition. Policymakers’inability to commit in advance to future policies gives rise to excessive in‡ation 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 in‡ation more than society does, can considerably reduce these welfare losse and that optimally the monetary authority is predominatly concerned about in‡ation. Full conservatism, i.e., exclusive concern about in‡ation, entirely eliminates the welfare losses from discretionary monetary and …scal policymaking, provided monetary policy is determined after …scal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with …scal policy or before …scal policy each period. Keywords: discretion, Nash and Stackelberg equilibria, policy biases, sequential noncooperative policy games JEL classi…cation: E52, E62, E63