Central Bank Independence and the Design of Fiscal Institutions

Abstract

We study the desirability of reforming fiscal institutions along with the delegation of monetary policy to an independent central bank. The model provides a rationale for discipline-enhancing fiscal institutions and highlights some of their desirable features. Three main results emerge. First, when the government can pre-commit on fiscal strategies, fiscal discretion is optimal only if the central bank strictly targets the socially optimal inflation rate. Second, without pre-commitment technology, fiscal restraints are desirable and contingent on the strategic interaction between monetary and fiscal authorities. Third, deficit rules are generally inefficient, and instrument-specific rules based on a combination of linear and quadratic contracts with targets are called for.

Keywords: central bank independence, policy mix, fiscal rules, linear and quadratic contracts with targets

JEL Classification: E52, E61, E62