Monetary and Fiscal Policy Interactions: Optimal Delegation and the Value of Leadership

Abstract

We consider monetary and fiscal policy interactions in a New-Keynesian model of a closed economy with a government solvency constraint. We study the problem of optimal delegation in the discretionary game with two optimising policymakers and provide a welfare ranking of different leadership regimes. We find that (1) if one policymaker chooses an aggressive (smooth) policy then the other policymaker must also choose an aggressive (smooth) policy, regardless of the leadership regime; (2) an institutional design that causes any policymaker to adopt an aggressive policy generally leads to welfare losses; (3) an institutional design that causes any policymaker to adopt a history-dependent policy is welfare increasing. Specific results obtained include showing that discretionary stabilisation policy by a conservative central bank reduces welfare, and that a 'speed limit' on fiscal policy improves social welfare as the central bank chooses to smooth the interest rate in equilibrium.

Keywords: Monetary and Fiscal Policy, Optimal Delegation, Discretion, Leadership Equilibria

JEL Classification: E31, E52, E58, E61, C61