CENTRAL BANK INDEPENDENCE AND THE MONETARY INSTRUMENT PROBLEM

We study the monetary instrument problem in a dynamic noncooperative game between separate, discretionary, fiscal and monetary policy makers. We show that monetary instruments are equivalent only if the policy makers' objectives are perfectly aligned; otherwise an instrument problem exists. When the central bank is benevolent while the fiscal authority is short-sighted relative to the private sector, excessive public spending and debt emerge under a money growth policy but not under an interest rate policy. Despite this property, the interest rate is not necessarily the optimal instrument. © (2013) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association