«POLICY BIASES WHEN THE MONETARY AND FISCAL AUTHORITIES HAVE DIFFERENT OBJECTIVES Herman Bennett Norman Loayza La serie de Documentos de Trabajo en ...»
Banco Central de Chile
Documentos de Trabajo
Central Bank of Chile
POLICY BIASES WHEN THE MONETARY AND
FISCAL AUTHORITIES HAVE DIFFERENT
Herman Bennett Norman Loayza
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Resumen Una aceptada primera generación de reformas relativas a la política fiscal y monetaria ha sido la independencia de los bancos centrales, la cual ha contribuido en forma esencial a lograr la estabilidad de precios y la disciplina fiscal que observamos actualmente en muchos países. Este trabajo estudia el potencial beneficio de una segunda generación de reformas, consistente en incentivos institucionales en favor de la coordinación doméstica entre las políticas fiscal y monetaria. Se presenta un modelo basado en teoría de juegos en el cual las autoridades monetarias y fiscales actúan con el fin de estabilizar la economía. Estas autoridades se diferencian por las preferencias que tienen respecto a las brechas de producto e inflación que muestra la economía y por controlar distintos instrumentos de política. La solución bajo falta de coordinación entre las autoridades, modelada ya sea como un equilibrio de Nash o Stackelberg, implica que una mayor divergencia entre las preferencias de las autoridades lleva, ceteris paribus, a un mayor nivel de déficit fiscal (el instrumento utilizado por la autoridad fiscal) y tasas de interés (el instrumento utilizado por la autoridad monetaria). Se examina esta hipótesis utilizando un panel de países industrializados con datos anuales para el período 1970-1994. Controlando por otros shocks y condiciones económicas, se encuentra evidencia significativa a favor de la hipótesis planteada. La implicancia de política de este trabajo es la siguiente: Sin perjuicio de los beneficios obtenidos por la primera generación de reformas, arreglos institucionales que permitan la coordinación, tanto al nivel de objetivos como de implementación de política, pueden aliviar el sesgo de mayores niveles de déficit fiscal y tasas de interés real.
Abstract Central bank independence has contributed to achieve price stability and fiscal discipline for many countries.
This is an accepted first-generation reform of fiscal and monetary policy. The question this paper asks is whether a second-generation reform consisting of institutional incentives for domestic policy coordination could be beneficial. The paper presents a game-theoretic model where the fiscal and monetary authorities interact to stabilize the economy. These authorities are different in that they have dissimilar preferences with respect to output and inflation gaps and control different policy instruments. Modeled as Nash or Stackelberg equilibria, the solution under lack of policy coordination implies that an increase in the preference divergence between the monetary and fiscal authorities leads to, ceteris paribus, larger public deficits (the fiscal authority's policy instrument) and higher interest rates (the central bank's instrument). The empirical section of the paper tests this conclusion on a pooled sample of 19 industrial countries with annual information for the period 1970-94. Controlling for other shocks and economic conditions, the estimation results support the main conclusion of the theoretical section. The policy implication of the paper is that, without prejudice to the gains from central bank independence, institutional arrangements that allow for coordination both at the level of setting objectives and at the level of policy implementation can alleviate the biases that move the economy to sub-optimally higher fiscal deficits and real interest rates.
This paper was prepared for the Third Annual Conference of the Central Bank of Chile “Monetary Policy:
Rules and Transmission Mechanisms”, Santiago, Chile, September 20-21, 1999. We are grateful to Guillermo Larraín, Daniel Lederman and Rodrigo Valdés for useful discussions and helpful comments. All remaining errors are our responsibility. As usual, the views expressed in this paper are those of the authors and do not necessarily reflect those of the Central Bank of Chile. Comments welcome to firstname.lastname@example.org and email@example.com.
1 Introduction Until recently, the debate on the relationship between monetary and ﬁscal authorities has been centered on the inﬂationary consequences of the monetary ﬁnancing of the ﬁscal deﬁcit. The moderate inﬂation of the 1970s in some industrialized countries and, particularly, the recurring episodes of high inﬂation in several developing countries justiﬁed this focus. The main policy recommendation to avoid high and variable inﬂation has been the institution of independent monetary authorities whose main mandate would be the control of inﬂation (see Cukierman 1992, and Walsh 1993).
In fact, in recent years several central banks have adopted inﬂation targeting as the cornerstone of their monetary policy (see Morand´ and Schmidt-Hebbel 1999).
e On the other hand, ﬁscal authorities have also come to recognize the harmful eﬀects of inﬂation and have taken measures to control their deﬁcits. This has been achieved by both rationalizing ﬁscal expenditures (e.g., eliminating price subsidies and privatizing public enterprises) and raising tax revenues, particularly through the adoption of value-added taxes. Furthermore, ﬁscal authorities are using domestic and international ﬁnancial markets to better manage the public debt to avoid the need to collect an inﬂation tax from outstanding monetary assets.
Thus, in many countries around the world there is a new policy environment, one in which monetary authorities are committed to controlling inﬂation and ﬁscal authorities do not rely on the inﬂationary tax to ﬁnance their deﬁcits and debt service.
In this new context, a diﬀerent set of policy issues and questions arise. This paper is devoted to the study of one of the most important of them, namely, the eﬀect of the lack of coordination between monetary and ﬁscal authorities in achieving the goals of minimizing business cycle ﬂuctuations.
Coordination (or the lack thereof) is a relevant issue because the monetary and ﬁscal authorities have diﬀerent policy instruments, diﬀerent objectives and preferences, and sometimes diﬀerent perceptions of the how the economy functions. In this paper we concentrate on the eﬀects of having monetary and ﬁscal authorities with dissimilar objectives and controlling diﬀerent policy instruments. In this sense, this paper is closely related to Nordhaus (1994) and Loewy (1988). Following these studies, we use a game-theoretic approach to analyze the eﬀects on ﬁscal deﬁcits and domestic real interest rates in a context where monetary and ﬁscal authorities are uncoordinated.
In this environment, monetary and ﬁscal authorities have dissimilar preferences for inﬂationary and growth gaps with respect to their long-run desired levels, which are assumed to be shared by both authorities.
As an introduction and in order to expose the main issues and results of the paper, we now present a simple ﬁscal-monetary game modeled after the well-known “prisoner’s dilemma.” Figure 1 presents the main assumptions and results of this game, in which we analyze the potential response of the monetary and ﬁscal authorities in the face of a negative shock that rises inﬂation and lowers employment. The monetary and ﬁscal authorities have two options each: they can either follow a loose or a tight policy. When both “play” tight, the resulting inﬂation is low but so is the resulting employment. When both play loose, both inﬂation and employment are high. And when only one of them plays tight, the result is medium employment and inﬂation.
The interesting feature of this ﬁscal/monetary game is that monetary and ﬁscal authorities have diﬀerent preferences for inﬂation and employment (see the payoﬀ schedules in Figure 1). Whereas the monetary authority considers more valuable to achieve low inﬂation than high employment, the ﬁscal authority regards obtaining high employment as more important than keeping inﬂation low. The preference differences between both authorities are chosen to be suﬃciently large so as to obtain the result we would like to stress.
The only Nash equilibrium in this game consists of a tight monetary policy and a loose ﬁscal policy. The other three alternatives present opportunities for one of the players to beneﬁt by unilaterally deviating from the original play. Thus, the equilibrium of this game exposes the paradigmatic conservatism of central banks and liberalism of ﬁscal authorities. It also illustrates why the response of each of them is optimal given the preference diﬀerences between the two. If the monetary authority were to follow a loose policy, thus accepting a ﬁscal authority’s pledge for stricter restraint, then the ﬁscal authority would ﬁnd it optimal to renege from its pledge and play a loose policy. By the same token, if the ﬁscal authority were to conduct a tight policy given a central bank’s oﬀer to follow a loose policy, the monetary authority would beneﬁt by deviating from its oﬀer by following a tight policy. Note that in terms of the payoﬀs to both authorities, the Nash equilibrium is equivalent to the combination of loose monetary and tight ﬁscal policies. From a long-run perspective, it can be argued that the latter combination of policies is healthier than
the Nash equilibrium given that it does not compromise ﬁscal sustainability and does not weaken the investment capacity of the private sector.
Though illustrative of the major themes of the paper, this simple game has obvious shortcomings. One of them is that it requires ad-hoc payoﬀ schedules to obtain the desired result. We may want to clarify the preference conditions under which policy biases occur. The second shortcoming is that the game does not consider the possibility for negotiations between the ﬁscal and monetary authorities that may
result in policy coordination.
In the second section of the paper we present a monetary/ﬁscal game where the potential advantages of policy coordination can be clearly seen. Through this model we also clarify the conditions under which looser ﬁscal policy (represented by higher primary ﬁscal deﬁcits) is accompanied by tighter monetary policy(represented by higher real interest rates), as predicted by the “prisoner’s dilemma” game. The basic conclusion of the model is that a rise in the preference divergence for output and inﬂation gaps between the monetary and ﬁscal authorities results in an increase of primary ﬁscal deﬁcits and real interest rates.
Also in the theoretical section, we compare the Nash equilibrium solution with the Stackelberg solution. By allowing one of the authorities to be the leader, the Stackelberg solution introduces dynamic aspects into the game, creating the possibility for the authority leader to act in a way to elicit a mutually beneﬁcial response from the follower. The Stackelberg game also obtains the basic conclusion of the Nash equilibrium; that is, independently of the who the leader is, a widening of the preference divergence leads to an expansion of ﬁscal deﬁcits and real interest rates.
However, by allowing the leader to seek a mutually beneﬁcial response from the follower, the Stackelberg equilibrium comes closer to the coordination solution than the Nash equilibrium does. 1 The third section of the paper attempts to bring some empirical evidence to bear.