DP6220 | Not published

Publication Date

23/04/2007

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Abstract

In this paper we examine the non-cooperative interactions between monetary and fiscal policy which emerge under discretion in a New Keynesian model with inflation persistence, when the economy is subject to a cost-push shock. We show that, when an impatient fiscal authority plays a Nash game with a central bank, we obtain a fight with high fiscal spending, high interest rates and rapid accumulation of debt. For certain values of inflation persistence, this outcome might actually be welfare improving. That is because it offsets the tendency for too little spending and too low interest rates that is caused by playing the game under discretion, as compared with commitment. But this result turns out to be only true if both the level of debt of the economy is very low and if the Phillips curve is pre-dominantly forward looking. With a reasonable steady state level of debt, monetary policy is forced to cut interest rates immediately after the shock, in order to return debt to its initial level. The higher spending which emerges in the Nash game, in such circumstances, ceases to raise welfare. If there is strong inflation persistence in the model then we show that, regardless of the steady state level of debt, such a Nash game leads to a costly 'civil war' outcome. We conclude that fiscal leadership delivers better outcomes than Nash for reasonable calibrations of our model. This conclusion remains true in the face of an alternative source of conflict, in which the fiscal policymaker is more risk averse than the monetary authority.