Designing Macroeconomic Frameworks: A Positive Analysis of Monetary and Fiscal Delegation*

Abstract

This paper proposes a simple model illustrating the potential benefits of approaching the design of a macroeconomic framework conducive to low inflation in both its monetary and fiscal dimensions rather than relying exclusively on the merits of central bank independence and other monetary commitment devices such as currency boards or dollarization. The reason is that monetary delegation alone merely 'relocates' the timeinconsistency problem stemming from the government's incentive to address structural output shortfall with a macroeconomic stimulus. This paper also provides a new argument explaining why fiscal deficit rules may be less effective than instrument-specific rules. Ã We benefited from insightful comments and suggestions by Roel Beetsma, Andrew Feltenstein, Robert Flood, the Editor (Benn Steil), Charles Wyplosz and seminar participants at the IMF. We are grateful to two anonymous referees for comments and suggestions that led to substantial improvements in many dimensions of the paper. Of course, the opinions expressed in this paper are those of the authors and do not necessarily reflect those of the International Monetary Fund (or IMF policies) nor the official position of the Inter-American Development Bank. We are also solely responsible for any remaining errors and omissions. r Blackwell Publishing Ltd. 2005, International Finance 8:1, 2005: pp. 87-117 Ã With centralized policy making, fiscal pre-commitment/discretion is irrelevant. ÃÃ If both monetary and fiscal authorities can pre-commit, then the game unravels to the CP regime. FD, fiscal discretion; FP, fiscal pre-commitment; FR, fiscal rules.

What should fiscal councils do?

“…In Agell et al (1996), a discretionary equilibrium exists with both inflation and deficit bias, and the government would be better off committing to inflation at target and budget balance. Castellani and Debrun (2005) show that institutional change that reduces inflation bias through monetary policy might encourage inflation bias through fiscal policy with an associated deficit bias. 6 If fiscal rules exist to deal with deficit bias arising from this type of time inconsistency, a fiscal council can act as a guardian of such rules when policy makers have incentives to depart from them.…”

Inflation Targeting and Fiscal Rules: Do Interactions and Sequencing Matter?

“…Second, those two restrictions are at odds with predictions from standard theories of optimal monetary and fiscal institutions. Clearly, improving the incentives of monetary and fiscal policymakers-the precise objective of these institutional reforms-is bound to affect the outcome of their strategic interaction (Beetsma and Bovenberg, 1997a, b;1998;Debrun, 2000;Beetsma, Debrun, andKlaassen, 2001 Dixit andLambertini, 2003;and Castellani and Debrun, 2005). This literature points not only to cross-effects between fiscal (monetary) outcomes and monetary (fiscal) frameworks, but also to interactions between the two types of reforms.…”

Independent Fiscal Agencies

“…While time inconsistency was a key argument behind the reform of monetary institutions (Rogoff, 1985), those very reforms may have aggravated the time‐inconsistency problem of fiscal policy because fiscal activism can potentially make up for the loss of monetary policy as an instrument to boost demand. Tying the latter to the mast (through rules or delegation) may thus encourage unwarranted, demand‐side fiscal expansions, essentially transforming the inflationary bias into a deficit bias (Agell et al , 1996; Castellani and Debrun, 2005).…”