Distortionary fiscal policy and monetary policy goals

Adam, Klaus ; Billi, Roberto M.

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URL: https://ub-madoc.bib.uni-mannheim.de/30173
URN: urn:nbn:de:bsz:180-madoc-301738
Document Type: Working paper
Year of publication: 2010
Place of publication: Mannheim
Publication language: English
Institution: School of Law and Economics > Geldpolitik und Makroökonomik (Adam 2008-2018)
Subject: 330 Economics
Classification: JEL: E52, E62, E63,
Keywords (English): discretion, Nash and Stackelberg equilibria, policy biases, sequential non- cooperative policy games
Abstract: We study interactions between monetary policy, which sets nominal interest rates, and fiscal policy, which levies distortionary income taxes to finance public goods, in a standard, sticky- price economy with monopolistic competition. Policymakers´inability to commit in advance to future policies gives rise to excessive inflation 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 inflation more than society does, can considerably reduce these welfare losse and that optimally the monetary authority is predominatly concerned about inflation. Full conservatism, i.e., exclusive concern about inflation, entirely eliminates the welfare losses from discretionary monetary and fiscal policymaking, provided monetary policy is determined after fiscal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with fiscal policy or before fiscal policy each period.

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