Policy Biases when the Monetary and Fiscal Authorities have Different Objectives

The question that this paper examines is what policy bias there may be when monetary and fiscal authorities have different preferences regarding the importance of closing the output and inflation gaps created by adverse economic shocks. For this purpose, the paper follows a game-theoretic approach to model the interaction between monetary and fiscal authorities, each having different preferences and controlling their respective policy instrument. Modeled as a Nash or Stackelberg equilibrium, the absence of policy coordination implies that an increase in the preference divergence between both authorities leads to, ceteris paribus, larger public deficits (the fiscal authority’s policy instrument) and higher interest rates (the central bank’s instrument). The empirical section of the paper provides evidence in favor of this conclusion in a pooled sample of 19 industrial countries with annual information for the period 1970-94. The policy implication of the paper is that, without prejudice to the gains from central bank independence, institutional arrangements that allow for monetary-fiscal coordination may alleviate the biases that move the economy to sub-optimally higher fiscal deficits and real interest rates.