Bureaucratic Corruption and the Dynamic Interaction between Monetary and Fiscal Policy

Work in Progress- Please do not quote without the author’s consent This paper analyses the dynamic interaction between fiscal and monetary policies under different levels of bureaucratic corruption. Building on the original Barro and Gordon (1983) model and explicitly formulating the fiscal authority, we find that all policy outcomes depend on the size of corruption the economy is faced with. Delegation of monetary policy to an independent central bank is attaining the second best solu-tion only if there is no bureaucratic corruption. However, with suboptimal institutional quality, the government has the incentive to increase debt strategically and indirectly ‘force ’ the central bank to pursue expansionary monetary policy, despite independence. This result is augmented by the size of bureaucratic corruption and poses difficulties on the achievement of both price stability and a balanced debt process. Bureaucratic corruption, hence, can provide an explanation for the poorer inflation performance, due to debt boosts, of countries with lower institutional quality despite the introduction of central bank independence. The implications of the theoretical model on debt ac-cumulation are verified empirically using a cross-sectional setting of 77 developed and developing countries. Confirming the theoretical predictions we find that after cen-tral bank independence is granted, more corruption leads to higher debt accumulation. More importantly, this effect is augmented by the degree of independence each central bank reform gave