Fiscal policy games lead to excessive public spending and inflation
The article explores whether it is still beneficial to have a conservative central bank in charge of controlling inflation when fiscal policy is also taken into account. The researchers used a model to simulate how monetary and fiscal policies interact in an economy with sticky prices and monopolistic distortions. They found that without a commitment to fiscal responsibility, there tends to be excessive public spending. In this scenario, having a conservative central bank is still important to keep inflation in check. When fiscal policy is decided before monetary policy each period, focusing on stabilizing inflation is crucial. Monetary conservatism helps to counteract the biases caused by lack of commitment in both monetary and fiscal policies, leading to a more optimal stabilization strategy.