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

41 Pages Posted: 6 Jun 2008

See all articles by Andrew J. Hughes

Andrew J. Hughes

Cardiff Business School; Centre for Economic Policy Research (CEPR); Vanderbilt University - College of Arts and Science - Department of Economics

Jan Libich

La Trobe University - Business School

Petr Stehlík

University of West Bohemia

Abstract

Monetary and Fiscal policies interact in many ways. Recently the stance of fiscal policy in a number of countries has raised concerns about the risks for the outcomes of monetary policy. This paper first shows that these concerns are justified since, under ambitious fiscal policy makers, inflation 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 solution, the paper proposes an asynchronous game framework that generalises the standard commitment analysis. It allows concurrent and partial commitment; both policies may be committed at the same time for varying degrees or different periods. It is demonstrated that these undesirable outcomes can be prevented if monetary commitment is sufficiently strong relative to fiscal commitment. Interestingly, monetary commitment can not only resist fiscal pressure, but also discipline an ambitious fiscal policy maker to achieve socially desirable outcomes for both policies. We extend the setting to the European monetary union case with a common central bank and many fiscal policy makers, to show that these results carry over. The implication therefore is: by explicitly committing to a long run inflation target, the central bank can not only ensure its credibility, but also indirectly induce more disciplined fiscal policies. The paper shows that these predictions are broadly supported empirically.

Keywords: asynchronous moves, Battle of sexes, commitment, Game of chicken, inflation targeting, monetary-fiscal interactions

JEL Classification: C73, E61, E63

Suggested Citation

Hughes Hallett, Andrew J. and Libich, Jan and Stehlík, Petr, Monetary and Fiscal Policy Interaction with Various Degrees and Types of Commitment. CEPR Discussion Paper No. DP6586, Available at SSRN: https://ssrn.com/abstract=1140515

Andrew J. Hughes Hallett (Contact Author)

Cardiff Business School ( email )

Aberconway Building
Cardiff CF10 3EU
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+44 292 087 001 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Vanderbilt University - College of Arts and Science - Department of Economics ( email )

Box 1819 Station B
Nashville, TN 37235
United States
615-322-8539 (Phone)
615-343-8495 (Fax)

Jan Libich

La Trobe University - Business School ( email )

La Trobe University
Bundoora, Victoria, Victoria 3083
Australia

Petr Stehlík

University of West Bohemia ( email )

Západoèeská univerzita v Plzni
Fakulta právnická, Sady Pìtatøicátníkù 14
Plzeò, 306 14
Czech Republic

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