Fiscal Dominance

Martin, Fernando M.

doi:10.20955/wp.2020.040

Working Paper Revision

Fiscal Dominance

Abstract: Central banks' resolve and independence is chronically tested by fiscal authorities wishing to impose their desired policies, often leading to socially undesirable economic outcomes. I study how the fiscal and monetary authorities' disagreement over outcomes and their choice of active instruments shape the implementation of policy, dispensing with commitment or first-mover advantage. I characterize the equilibrium for various combinations of active (and correspondingly, passive) instruments, identify which sources of disagreement play a role in each case, and show whether and under what conditions time-consistency problems may disappear in the long-run. Fiscal dominance may only arise when the fiscal authority actively sets debt levels and lets tax rates adjust passively to satisfy the government budget constraint. In this case, the central bank's choice of instrument becomes immaterial, though endowing it with a special concern for liquidity markets counteracts this result.

Keywords: discretion; time-consistency; government debt; deficit; inflation; institutional design; political frictions; fiscal dominance; central bank independence; active vs passive policies; unpleasant monetarist arithmetic;