Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility |
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Authors: | Andrew Hughes Hallett Jan Libich |
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Institution: | (1) School of Public Policy, George Mason University, Fairfax, VA 22030, USA;(2) CEPR, London, UK;(3) School of Business, La Trobe University and CAMA, Melbourne, Victoria, 3086, Australia |
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Abstract: | This paper offers new insights into the interactions between private agents, the government, and a central bank, and their
effect on the outcomes of monetary policy. In a simple game theoretic model we show that, unless there is public monitoring,
impatient governments will be tempted to override or outmaneuver the central bank and create surprise inflation to boost output.
This both undermines the government’s reputation for sound fiscal policies and reduces the central bank’s credibility. The
result is not only higher and more volatile inflation but also sub-optimal output. More importantly, it is also shown that
this is likely to occur even if the central banker is fully independent and the government is always patient. In contrast,
if the public monitors sufficiently carefully, the central bank is never overridden and monetary policy can be credible even
under an impatient government. We derive the general conditions under which each scenario occurs and then relate them to the
developments in central banking over the past two decades, most notably to the trends towards greater independence, explicit
inflation targeting, clearer communication and transparency. Interestingly, transparency is shown to reduce the variability
of both inflation and output (by reducing the monitoring cost and making public monitoring more likely) which is in contrast
to the usual transparency literature with a single policymaker which supposes a transparency-volatility trade-off.
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Keywords: | Monetary-fiscal interaction Reputation Credibility Overriding Monitoring Central bank independence Inflation targeting Transparency |
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