The Central Bank Strikes Back! Credibility of Monetary Policy under Fiscal Influence

Central banks in many advanced economies enjoy a high degree of independence, which protects monetary policy decisions from political influence. Typically, a government’s fiscal policy is responsible for taxes, debt and deficits, while the central bank’s objectives focus on price stability. This policy arrangement—with its strict separation of assignments—is widely seen as having been instrumental in avoiding monetary policy decisions that could lead to higher-than-optimal levels of inflation.

However, rising levels of public debt have triggered mounting political pressure and government interference with some central banks. This tension creates the risk of a shift away from the conventional arrangement to one in which monetary policy becomes mostly subordinate to fiscal policy decisions. We study how this risk affects the design of monetary policy. We use a model with both a monetary and a fiscal authority that interact non-cooperatively and have different degrees of commitment.

Specifically, we examine whether a central bank should design a monetary policy framework that prescribes acting conditionally on how fiscal policy behaves. We find that such a framework not only improves economic outcomes by providing appropriate incentives to the fiscal authority but also may enhance the central bank’s credibility.