Inflation conservatism and monetary-fiscal policy interactions

Abstract

This paper investigates the stabilization bias that arises in a model of monetary and fiscal policy stabilization of the economy, when monetary authority puts higher weight on inflation stabilization than society. We demonstrate that inflation conservatism unambiguously leads to social welfare losses if the fiscal authority acts strategically under discretion. Although the precise form of monetary-fiscal interactions depends on the leadership structure, the choice of fiscal instrument, and the level of steady-state debt, the assessment of gains is robust to these assumptions. We develop an algorithm that computes leadership equilibria in a general framework of LQ RE models with strategic agents.