Monetary policy,fiscal policy and cross signal jamming

This paper considers the issue of rule versus discretion when the central bank and the government share private information but have different preferences over inflation and output. We demonstrate that if the monetary policy is rule-based, Intuitive Criterion selects the unique separating equilibrium in which the central bank signals a low supply shock by a low interest rate. Interestingly, discretion may be better than the rule for the central bank, contrary to the case of complete information. Also, we examine the effect of information asymmetry on the monetary and fiscal policy mix. We show that cross signal jamming whereby the monetary authority and the fiscal authority successfully jams an unfavorable signal of each other does not occur in equilibrium.     

United we stand: on the macroeconomics of a Fiscal union

In this paper, we apply dynamic tracking games to macroeconomic policy making in a monetary union. We use a small stylized nonlinear two-country macroeconomic model of a monetary union for analyzing the interactions between two fiscal (governments: “core” and “periphery”) and one monetary (central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm, we calculate numerical solutions for cooperative (Pareto optimal) and non-cooperative games (feedback Nash). We show how the policy makers react to adverse demand shocks. We investigate the consequences of three scenarios: decentralized fiscal policies controlled by independent governments (the present situation), centralized fiscal policy (a fiscal union) with an independent central bank (pure fiscal union), and a fully centralized monetary and fiscal union. For the latter two scenarios, we demonstrate the importance of different assumptions about the joint objective function corresponding to different weights for the two governments in the design of the common fiscal policy. We show that a fiscal union with weights corresponding to the number of states in each of the blocs gives better results than non-cooperative policy making. When one bloc dominates the fiscal union, decentralized policies yield lower overall losses than the pure fiscal union and the monetary and fiscal union.     

HETEROGENEITY IN A CURRENCY UNION WITH SOCIAL MARKET OBJECTIVES

In this paper, we explore whether heterogeneity among union members could threaten the stability of the European Monetary Union. The types of heterogeneity we consider are (1) asymmetries in the transmission of monetary and fiscal policies, and (2) differences in national preferences for price stability, output growth, and income redistribution. Our results show that the costs of membership can be significant for countries whose transmissions, structure, or preferences deviate from those underlying the common monetary policy. In part, these costs arise because monetary policy imposed by an independent central bank automatically constrains the use of fiscal policy by national governments.     

CENTRAL BANK INDEPENDENCE AND THE MONETARY INSTRUMENT PROBLEM

We study the monetary instrument problem in a dynamic noncooperative game between separate, discretionary, fiscal and monetary policy makers. We show that monetary instruments are equivalent only if the policy makers' objectives are perfectly aligned; otherwise an instrument problem exists. When the central bank is benevolent while the fiscal authority is short‐sighted relative to the private sector, excessive public spending and debt emerge under a money growth policy but not under an interest rate policy. Despite this property, the interest rate is not necessarily the optimal instrument.     

Long-term appointment of central bankers: costs and benefits

Why do independent central bank boards have a reputation for more moderate policy than do elected governments, even if the board's members have been appointed by the current or former government? This paper gives an explanation for the case of a political world with ‘zeitgeist shocks’ on the electorate's preferences. If the median position of preferences inside the board determines the monetary policy, a trade-off concerning member term length arises: a longer term entails more moderation, while enhancing the likelihood of detachment from contact to the electorate's current preferences.     

Independent but Not Indifferent: Partisan Bias in Monetary Policy at the Fed

Independent central banks are thought to be effective inflation hawks because they are run by technocrats with conservative monetary policy preferences. However, central bankers can only protect their independence by compromising with the elected officials who grant them their independence. Policy, therefore, is likely to be a weighted average of the preferences of the central bank and the government. Consequently, central bankers may be eager to help right‐wing governments stay in power and oppose the election of left‐wing governments. We show evidence from the United States that interest rates (a) decline as elections approach when Republicans control the White House, but rise when Democrats do; and (b) are sensitive to the inflation rate (output gap) when Democrats (Republicans) are in the White House. Thus, the Federal Reserve is a conditional inflation hawk. Since the Fed became operationally independent in 1951, the Republicans have exhibited a decided electoral advantage in presidential politics.     

INTERACTION BETWEEN MONETARY AND FISCAL AUTHORITIES UNDER INCOMPLETE INFORMATION

This paper analyzes the interaction between monetary and fiscal authorities under incomplete information. The inflation goal of the central bank is assumed to be unknown to the fiscal authority and the public. The central bank signals the goal by choosing the first‐period monetary policy before the fiscal authority joins the policy‐making game. If the central bank would like the fiscal authority and the public to believe that it is wet (dry), the central bank would distort the money supply upward (downward) in order to reveal its actual type.     

“Core” and “Periphery” in a Monetary Union: A Macroeconomic Policy Game

We develop a dynamic game model of a two-country monetary union to study strategic interactions between macroeconomic policy makers, namely the central bank and governments. In this union, the governments of participating countries pursue national goals when deciding on fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objective variables. The union considered is asymmetric, consisting of a core, with lower initial public debt, and a periphery, with higher initial public debt. For a symmetric demand shock, we derive numerical solutions of the dynamic game between the governments and the central bank using the OPTGAME algorithm. We show that mildly active cooperative countercyclical policies dominate noncooperative solutions and a scenario of no policy intervention. Optimal policies call for a brief expansionary action to bolster the effects on output and a return to a small fiscal primary surplus as soon as the crisis is over until the targeted level of public debt is reached.     

Overturning Mundell: Fiscal Policy in a Monetary Union

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell (1961) : a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable.
This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks.     

Floor systems for implementing monetary policy: Some unpleasant fiscal arithmetic

An increasing number of central banks implement monetary policy via a channel system or a floor system. We construct a general equilibrium model to study the properties of these systems. We find that a floor system is weakly optimal if and only if the target rate satisfies the Friedman rule. Unfortunately, the optimal floor system requires either transfers from the fiscal authority to the central bank or a reduction in seigniorage payments from the central bank to the government. This is the unpleasant fiscal arithmetic of a floor system. When the central bank faces financing constraints on its interest expense, we show that it is strictly optimal to operate a channel system.     

Monetary and fiscal institutional designs

Two investment decisions in economic institutions are feasible; investments in monetary institutions in the form of delegation of monetary policy to a more conservative or independent central bank, and investments in fiscal capacity, in the form of combating bureaucratic corruption and its consequent fiscal revenue leakages. Within this framework, we investigate the interactions among those two institutional decisions and the obtained institutional structure. The findings provide support of strategic complementarities; investments in monetary and fiscal institutions reinforce each other. In addition, we identify a set of determinants that impact on the government’s decisions to improve economic institutions, particularly, the structure and intensity of the initial corruption level, the amount of distortions caused by taxation and the policymaker’s goals and preferences across its objectives.     

Monetary–fiscal policy interaction and fiscal inflation: A tale of three countries

We study the impact of the interaction between fiscal and monetary policy on the low-frequency relationship between the fiscal stance and inflation using cross-country data from 1965 to 1999. In a first step, we contrast the monetary–fiscal narrative for Germany, the U.S., and Italy with evidence obtained from simple regression models and a time-varying VAR. We find that the low-frequency relationship between the fiscal stance and inflation is low during periods of an independent central bank and responsible fiscal policy and more pronounced in times of non-responsible fiscal policy and accommodative monetary authorities. In a second step, we use an estimated DSGE model to interpret the low-frequency measure structurally and to illustrate the mechanisms through which fiscal actions affect inflation in the long run. The findings from the DSGE model suggest that switches in the monetary–fiscal policy interaction and accompanying variations in the propagation of structural shocks can well account for changes in the low-frequency relationship between the fiscal stance and inflation.     

Budget uncertainty in a monetary union

Governments in a monetary union fear spending disturbances. We distinguish them according to their ability to hedge against these disturbances and assume that they derive their optimal fiscal decisions by using a robust control approach. Results show that governments being highly vulnerable to spending disturbances set excessive tax rates, thereby exacerbating the fiscal pressure detrimental to output and obliging the central bank to conduct an expansionary monetary policy. Countries whose governments have higher ability to hedge against spending disturbances then suffer from the inflationary consequences of this monetary policy.     

Discretionary policy in a monetary union with sovereign debt

This paper examines the interactions between multiple national fiscal policymakers and a single monetary policy maker in response to shocks to government debt in some or all of the countries of a monetary union. We assume that national governments respond to excess debt in an optimal manner, but that they do not have access to a commitment technology. This implies that national fiscal policy gradually reduces debt: the lack of a commitment technology precludes a random walk in steady-state debt, but the need to maintain national competitiveness avoids excessively rapid debt reduction. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However, if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with significant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.     

Monetary and Fiscal Policy Interactions in the Euro Area

The problem of monetary and fiscal policy interactions is an important issue for the euro area, since the individual member states of the EMU are responsible for their fiscal policies but monetary policy is pursued by a single monetary authority, the ECB. This paper is concerned with empirical evidence on monetary and fiscal policy interactions in the euro area. We first explore fiscal regimes with a VAR model and find empirical evidence that a non-Ricardian fiscal policy has been pursued in both France and Germany. As an example, we then study how one member state of the EMU, namely, Italy, is responding to the common monetary policy with its fiscal policy and find that Italian fiscal policy seemed to be counteractive to the common monetary policy between 1979 and 1998. In order to study monetary and fiscal policy interactions in a more general way, we explore time-varying interactions by estimating a State-Space model with Markov-switching for some Euro-area countries. There appear to be some regime changes in monetary and fiscal policy interactions in France and Germany, but the interactions between the two policies are not strong. Moreover, the two policies have not been accommodative but counteractive to each other. Finally we explore forward-looking behavior in policy interactions and find that expectations do not seem to have played an important role in the policy designs.     

Is Delegating Half of Demand Management Sensible?

One objection to delegating monetary policy to an independent central bank is that it causes lack of coordination with fiscal policy. Nordhaus has recently shown, in a simple game-theoretic model, how this generates too-contractionary monetary policy and too-expansionary fiscal policy, with interest rates becoming excessively high. In this note we incorporate the time-consistency, inflation-bias problem into the analysis, since it is this that has motivated most proposals for granting independence. We show that when the inflation-suppressing benefits are modelled alongside the high-interests rate costs, delegation may still be, on balance, against society's interests.     

Inflation and the fiscal limit

We use a rational expectations framework to assess the implications of rising debt in an environment with a “fiscal limit”. The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.     

Fiscal leadership and central bank design

Abstract.  This article investigates the impact, on economic performance, of the timing of moves in a policy game between the government and the central bank for a government that has both redistributional and stabilization objectives. It is shown that both inflation and income inequality are reduced without sacrificing output growth if the government assumes a leadership role compared with a regime in which monetary and fiscal policy are determined simultaneously. Further, it is shown that government leadership benefits both the fiscal and monetary authorities through the enhanced coordination that this arrangement implies.     

The Macroeconomic Management of Increased Aid: Policy Lessons from Recent Experience

The authors investigate the macroeconomic challenges created by a surge in aid inflows. They develop an analytical framework for examining possible policy responses to increased aid, in terms of absorption and spending of aid—where the central bank controls absorption, through monetary policy and the sale of foreign exchange, and where the fiscal authority controls spending. Different combinations of absorption and spending lead to different macroeconomic consequences. Evidence from five countries that recently experienced an aid surge (Ethiopia, Ghana, Tanzania, Mozambique, and Uganda) shows no support for aid-related real exchange rate appreciation in these countries, but it does indicate that the fear of Dutch disease played an important part in the policy reaction to aid surges. Fiscal and monetary authorities should coordinate their responses to an aid surge, because an uncoordinated response—typically when the fiscal authority wants to spend aid while the central bank wants to avoid exchange rate appreciation—can have serious negative macroeconomic consequences.     

Fiscal Transfers in a Monetary Union with Exit Option

It is widely debated whether a monetary union has to be accompanied by a fiscal transfer scheme to accommodate asymmetric shocks. We build a model of a monetary union with a central bank and two heterogeneous countries that are linked by a fiscal transfer scheme with repercussions on monetary policy. A central bank aiming at securing the existence of a monetary union in the presence of asymmetric shocks has to compensate single countries for the tax distortions arising from fiscal transfers. Monetary policy may become more expansionary or restrictive depending on asymmetries between member countries' inflation aversion and exit costs.