The issue of the credibility of macroeconomic policies has been first analyzed from a formal perspective by Kydland and Prescott (1977) and Calvo (1978). In the subsequent literature, it has turned out as a pervasive feature of dynamic models of optimal policy making that desirable policies may suffer from a lack of credibility when the policy maker cannot command a non-distortionary policy instrument. In such environments, the socially optimal policy in the absence of ex-post incentive constraints generally yields a second best outcome. However, if the policy maker does not have access to a commitment technology, the prediction is that such second best policies cannot be implemented because the costs of policy decisions are not fully internalized by the policy maker. The well-known reason behind this time con-sistency problem is that a sequential decision maker, in taking private expectations as given, neglects the influence of his current policy choices on the past formation of the public’s forward-looking expectations. The problem of time inconsistency can then be dealt with in several ways. The ideas generally evolve around introducing some form of indirect commitment through the design of appropriate institutions like rules, contracts, delegation or a richer set of policy instruments with built-in ir-reversibilites. With an infinite time horizon, another way to reach ”good” outcomes even without commitment is to rely on reputational mechanisms. For example, Barro and Gordon (1983b) have illustrated in a repeated setting how reputational forces can substitute for formal rules by constructing a policy equilibrium where a simple trigger strategy governs the public’s formation of expectations.
In the present paper, we explicitly acknowledge the fact that policies are imple-19
mented sequentially and assume that (i) a commitment technology is not available and that (ii) reputational mechanisms are not at work. We then identify a new mechanism which can help to overcome the time consistency problem faced by a single decision making unit. Specifically, we show how the decentralization of deci-sion authority over the available policy instruments among interacting policy makers can change the latters’ dynamic incentive constraints in a way that eliminates the temptation to surprise the public. It is worthwhile to stress that our concept of decentralization does not employ reputation or other history-dependent punishment mechanisms. While our results are derived in the context of a particular model, we believe that the identified mechanism has more general relevance.
The model framework considered is a simple monetary dynamic general equilib-rium economy without capital, as introduced by Lucas and Stokey (1983). In such an economy, D´ıaz-Gim´enez et al. (2006) analyze from an optimal taxation perspective the dynamic distortions that are caused by outstanding nominal government debt.
With a particular specification of preferences,1 their central findings for the case of a monolithic single policy maker who controls both monetary and fiscal policy in-struments are the following: With nominal one-period debt (and unindexed bonds), there is an incentive to reduce the stock of debt through unanticipated inflation be-cause the lump-sum aspect of the inflation tax allows to economize on distortionary taxation; this creates the standard time inconsistency problem. In the rational ex-pectations equilibrium, the ex-post incentive to generate inflation increases the costs of outstanding debt even if there are no unanticipated inflation episodes. Therefore, the optimal policy under sequential choice and no commitment is to progressively deplete the outstanding stock of debt until the extra liability costs vanish. The au-thors’ general message thus is that, with nominal debt and sequential policy making, the optimal policy (inflation) will not only depend on elasticities as in a standard model of Ramsey-optimal taxation, but also on the marginal gain from changing the real value of the existing debt.
In the present paper, we reconsider this dynamic policy making problem from a strategic perspective with interaction between monetary and fiscal policy. This makes it necessary to resort to game-theoretic methods. Since our starting point is that reputational mechanisms cannot be relied upon, a natural way to analyze the dynamic evolution of the economy is to consider Markov-perfect equilibria (MPE) only. With this class of strategies, the past influences the current play only through its effect on a set of state variables which summarize the direct effect of the past on the current environment. While the restriction to MPE comes at the cost of not being able to identify all equilibria that can possibly be sustained (e.g. by means of history-dependent reputational mechanisms), it has the advantage of imposing
1Martin (2006) generalizes the results obtained by D´ıaz-Gim´enez et al. (2006); we will return to this issue below.
only minimal informational requirements on the policy makers and of facilitating the identification of differentiable equilibria by first order conditions which allow for a straightforward economic interpretation.
Our model setup differs from a standard model of optimal policy only along one dimension, namely the introduction of a second policy authority. Given the institu-tional provisions prevailing in most advanced economies, we see the assumption of two interacting policy authorities who take their decisions independently, but sub-ject to a consolidated government budget constraint as a realistic one. Nevertheless, the paper’s main point is of a conceptual nature. Starting from the results in D´ıaz-Gim´enez et al. (2006), we deal with the case of a dynamic game where policies are implemented sequentially, but, in each period, the two authorities move simultane-ously. The key finding is that with decentralized authority over the relevant policy instruments, the supply of money balances and a linear consumption tax, there is scope for coordinating private expectations in a favorable way. Specifically, the MPE allocation from the case of a single policy maker is no longer the only equilibrium out-come, and the previously identified inflation bias may vanish even for positive levels of outstanding government debt. With such multiplicity of equilibria, expectations about the future play are key to pin down current policy choices. The presence of an independent fiscal authority lacking access to a non-distortionary policy instrument introduces an additional constraint on implementable allocations faced by the mon-etary policy maker; the reason is that the current fiscal policy needs to be taken as given rather than as a free choice variable. Hence, unlike the standard setup where a monolithic sequential policy maker uses the inflation tax to substitute for the fiscal consumption tax, under interaction it is the case that distortions introduced by the current fiscal play cannot be removed. The consequence is that the welfare costs of imposing on private agents the inflation tax in addition to the fiscal consumption tax may become excessively high. Therefore, private expectations about a continuation play not subject to an inflation bias become rational. And given such expectations, there is room for current policies generating enough fiscal revenue to keep the level of government debt constant without recurring to the inflation tax. Hence, besides the single-agency equilibrium described in D´ıaz-Gim´enez et al. (2006) there exists also a MPE where the associated dynamically consistent policies implement a true second best outcome. Thus, while the established view from the public finance literature suggests that fiscal (mis)behavior may contribute to the monetary time consistency problem, this paper highlights a mechanism working in the opposite direction: It is precisely the presence of a dynamically optimizing fiscal authority which may help to put discipline on the monetary authority’s dynamic choices.
The rest of the paper is organized as follows. The following section sets up the model and defines a competitive equilibrium for our economy. Then, section 3 lays out the structure of the policy game between the monetary and the fiscal authority.
Section 4 briefly comments on the solution strategy to find the MPE, before the subsequent section establishes the existence of a MPE and describes the equilibrium outcomes. Finally, the paper concludes with a review of the related literature and some further remarks. Technical details are relegated to the Appendix.