Strategic Interactions between an Independent Central Bank and a Myopic Government with Government Debt

Author/Editor:

Sven Jari Stehn ; David A Vines

Publication Date:

July 1, 2008

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

We analyse optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model. First, when lump-sum taxes are available and public debt is absent, we show that a Nash game results in too much government spending and excessively high interest rates, while fiscal leadership reinstates the cooperative outcome under discretion. Second, we show that this familiar result breaks down when lump-sum taxes are unavailable. With government debt, the Nash equilibrium still entails too much public spending but leads to lower interest rates than the cooperative policy, because debt has to be adjusted back to its pre-shock level to ensure time consistency. A setup of fiscal leadership does not avoid this socially costly outcome. Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially, while appointing a conservative central bank is less effective.

Series:

Working Paper No. 08/164

Subject:

English

Publication Date:

July 1, 2008

ISBN/ISSN:

9781451870220/1018-5941

Stock No:

WPIEA2008164

Price:

$18.00 (Academic Rate:$18.00)

Format:

Paper

Pages:

38

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