Distortionary Taxation and Central Bank Design

Abstract

We consider a monetary union where distortionary taxation leads to the classical inflation bias in discretionary monetary policy. We show that a more generous welfare state requires a more conservative central bank. This result rationalizes the perception that the European Central Bank is more focused than the U.S. Federal Reserve on putting a lid on inflation but less worried about deflation. Besides, when an economic crisis increases the welfare state costs for countries in the periphery of the union, making the common central bank more conservative will improve welfare not only in the core countries but also in the periphery.

Essays on fiscal and monetary policy interactions in a monetary union

“…At this point, following Rogoff (1985a), we can consider the optimal weight of interest-rate smoothing that the social planner would place on the monetary authority. We also follow the work of Hughes Hallett (2008a,b), Andersen (2008) and Campoy and Negrete (2012). In particular, we assume that at stage 0, before the realisation of shocks, the social planner chooses the degree of interest-rate smoothing in order to minimise social loss for a given degree of central bank's conservativeness and under supply shocks.…”

“…The author assumes that there is a given weight to output stabilisation in the social loss function and the assignment question is how to split the task of output stabilisation between the monetary and the fiscal authorities. In Campoy and Negrete (2012), the national fiscal authorities collectively design their common central bank by agreeing on the inflation target to be aimed at by this monetary institution.…”