Fiscal Dominance and Central Bank Independence

RePEc Short ID: pma339
ORCID iD: 0000-0001-5045-7998

Martin, Fernando M.

doi:10.20955/wp.2020.040

Working Paper Revision

Fiscal Dominance and Central Bank Independence

Abstract: I study policy when fiscal and monetary authorities disagree, cannot commit to future actions and move simultaneously. This approach shifts attention from active and passive authorities or policies to active and passive instruments, and allows formal definitions of fiscal dominance and central bank independence. In the benchmark case, an independent central bank sets the short-term rate and the fiscal authority sets taxes and spending: fiscal dominance cannot arise, but time-consistency problems remain. Fiscal dominance can arise when the fiscal authority actively sets debt growth instead. Balance-sheet policy and yield curve control are effective means of countering fiscal pressures. Active control of monetary aggregates provides a contrasting case in which fiscal dominance cannot arise. Finally, I find that government authorities endowed with active instruments retain agency when facing competing authorities adopting ex ante policy rules.

JEL Classification: E52; E58; E61; E62;

https://doi.org/10.20955/wp.2020.040