Stabilizing Output and Inflation: Policy Conflicts and Co‐operation under a Stability Pact

Abstract

The article analyses in a simple setting a game between an inflationconservative central bank and a fiscal authority subject to an upper limit on the budget deficit. It is shown that complementarity or substitutability between the policies and the preference of each authority for the other authority's behaviour crucially depends on the type of shock hitting the economy. If the government attempts to stimulate output beyond its natural level, a 'deficit bias' emerges under non-co-operation; under co-operation, the equilibrium is characterized by both a 'deficit bias' and an 'inflation bias'. However, if the government only pursues cyclical stabilization these biases disappear and there are positive gains from co-ordinating the policy responses to shocks. * Earlier versions of this article have been presented in several conferences and workshops. We would like to thank discussants and participants for thoughtful comments. In particular, we are grateful to Ralph Bryant, Luisa Lambertini and, especially, Jacques Mélitz. We are also indebted to a number of Commission colleagues, two anonymous referees and the editor of this journal for valuable comments. Maarten van de Stadt provided excellent research assistance. The opinions expressed are those of the authors only and should not be attributed to the European Commission. The usual disclaimer applies. 802

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