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Looking Beyond the Trap: Fiscal Legacy and Central Bank Independence

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  • Charles de Beauffort

Abstract

I model a stochastic non‐cooperative game between an independent central bank and a treasury and study optimal time‐consistent policy in the context of demand‐driven recessions and an occasionally binding zero lower bound constraint. Departing from coordination leads to contractionary fiscal policy in the liquidity trap. The persistent decline in short‐term government debt improves price stability and welfare albeit at the expense of a deeper recession in the near term. Underlying this policy is the anticipated risk of monetary tightening during the economic recovery in response to fiscally induced inflation. The issuance of long‐term government debt helps to buffer the yield to maturity against interest rate fluctuations, thereby reducing the relevance of central bank independence for macroeconomic outcomes.

Suggested Citation

  • Charles de Beauffort, 2024. "Looking Beyond the Trap: Fiscal Legacy and Central Bank Independence," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 86(2), pages 385-416, April.
    • Handle: RePEc:bla:obuest:v:86:y:2024:i:2:p:385-416
    DOI: 10.1111/obes.12580
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