Fiscal Dominance

Martin, Fernando M.

doi:10.20955/wp.2020.040

Working Paper Revision

Fiscal Dominance

Abstract: Who prevails when fiscal and monetary authorities disagree about the value of public expenditure and how much to discount the future? When the fiscal authority sets debt as its main policy instrument it achieves fiscal dominance, rendering the preferences of the central bank, and thus its independence, irrelevant. When the central bank sets the nominal interest rate it renders fiscal impatience (its debt bias) irrelevant, but still faces its expenditure bias. I find that the expenditure bias has a major impact on welfare through higher public spending, while the effect on other policies is relatively minor. In contrast, the debt bias affects debt, deficits and inflation, but has a minor impact on expenditure and welfare. I also find that the central bank can do little to overcome the negative impact of the fiscal authority’s expenditure bias, though there are still gains from properly designing the central bank.

Keywords: discretion; time-consistency; government debt; deficit; inflation; institutional design; political frictions;

JEL Classification: E52; E58; E61; E62;

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