Fiscal Dominance

Martin, Fernando M.

doi:10.20955/wp.2020.040

Working Paper Revision

Fiscal Dominance

Abstract: Central banks' resolve and independence are 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. When the fiscal authority sets debt levels actively, it may be able to impose its preferences on the central bank, regardless of how monetary policy is conducted. Designing a central bank 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;