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

IMF Working Papers, July 1, 2008

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

Model: Optimal discretionary games between a benevolent central bank and a myopic government in a New Keynesian model.
Case 1 — lump-sum taxes available and public debt absent:
- A Nash game results in too much government spending and excessively high interest rates.
- Fiscal leadership reinstates the cooperative outcome under discretion.
Case 2 — lump-sum taxes unavailable (with government debt):
- The familiar result from Case 1 breaks down.
- 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.
Policy tools evaluated:
- Imposing a debt penalty onto the myopic government under either Nash or fiscal leadership raises welfare substantially.
- Appointing a conservative central bank is less effective.

Where lump-sum taxation and absence of public debt can be assumed, fiscal leadership can restore cooperative discretionary outcomes and mitigate excessive spending and high interest rates.
When government debt is present and lump-sum taxes are unavailable, fiscal leadership does not prevent socially costly outcomes; alternative restraints on fiscal behavior are needed.
Directly penalizing deviation in debt outcomes (a debt penalty on the myopic government) is recommended as it raises welfare substantially under both Nash and fiscal leadership setups.
Relying solely on appointing a conservative central bank is a less effective strategy for addressing the distortions caused by a myopic government with debt.