Strategic Interactions Between An Independent Central Bank And A Myopic Government With Government Debt

40 Pages Posted: 21 Sep 2009

See all articles by Sven Jari Stehn

Sven Jari Stehn

Brasenose College; International Monetary Fund (IMF)

David Vines

University of Oxford - Balliol College - Department of Economics; Australian National University (ANU); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: July 2008

Abstract

We analyse optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model. First, when lump-sum taxes are available and public debt is absent, we show that a Nash game results in too much government spending and excessively high interest rates, while fiscal leadership reinstates the cooperative outcome under discretion. Second, we show that this familiar result breaks down when lump-sum taxes are unavailable. With government debt, the Nash equilibrium still entails too much public spending but leads to lower interest rates than the cooperative policy, because debt has to be adjusted back to its pre-shock level to ensure time consistency. A setup of fiscal leadership does not avoid this socially costly outcome. Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially, while appointing a conservative central bank is less effective.

Keywords: Central banks, Monetary authorities, Intergovernmental fiscal relations, Government expenditures, Fiscal policy, Stabilization measures

Suggested Citation

Stehn, Sven Jari and Vines, David, Strategic Interactions Between An Independent Central Bank And A Myopic Government With Government Debt (July 2008). IMF Working Papers, Vol. , pp. 1-38, 2008. Available at SSRN: https://ssrn.com/abstract=1475509

Sven Jari Stehn (Contact Author)

Brasenose College ( email )

Oxford OX1 4AJ
United Kingdom

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

David Vines

University of Oxford - Balliol College - Department of Economics ( email )

Manor Road
Oxford, OX1 3BJ, Oxfordshire OX13UQ
United Kingdom
+44 1865 271 067 (Phone)
+44 1865 271 094 (Fax)

Australian National University (ANU)

Canberra, Australian Capital Territory
Australia

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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