Monetary Exit Strategy and Fiscal Spillovers
17 Pages Posted: 15 May 2011
Date Written: May 13, 2011
The paper models monetary-fiscal interactions in the aftermath of an economic downturn and presence of fiscal stress. It focuses on the strategic aspect of the interaction between the central bank and the government that features both a conflict and a coordination problem in line with Sargent and Wallace (1981) and Leeper (1991). In contrast to the standard game, our framework allows for deterministic and stochastic revisions of policy actions generalizing the Stackelberg leadership concept. We identify several variables that determine the outcomes of the policy interaction. Most importantly, we find that a legislated long-term monetary commitment may: (i) reduce the risk of a double-dip recession and deflation in the short-term, and at the same time (ii) facilitate the 'exit strategy' of monetary policy, ie prevent sub-optimally high future inflation caused by fiscal spillovers. Our analysis thus implies that an explicit numerical target for average inflation may play the role of a monetary 'credibility insurance' over all phases of the business cycle, and is beneficial especially in countries facing fiscal stress. We extend the analysis to a monetary union with various types of governments and free-riding, and show that if the combined size of responsible governments is below a certain threshold then even an infinitely strong monetary commitment is insufficient to ensure price stability.
Keywords: monetary-fiscal interactions, Game of Chicken, fiscal stress, asynchronous moves, stochastic timing, equilibrium selection
JEL Classification: E52
Suggested Citation: Suggested Citation