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

_IMF Working Papers, July 1, 2008_

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## Bibliographic details
- Authors: Sven Jari Stehn, David A Vines
- Published: July 1, 2008
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451870220.001

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### Summary findings
- 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.

### Policy implications and recommendations
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/strategic-interactions-between-an-independent-central-bank-and-a-myopic-government-with-22078_