Optimal Structure of Fiscal and Monetary Authorities

• Published date: 01 March 2019
• Author: DAVID S. MILLER
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jmcb.12606

DOI: 10.1111/jmcb.12606

DAVID S. MILLER

Optimal Structure of Fiscal and Monetary

Authorities

Why are monetary authorities not elected like fiscal authorities are? Ad-

vanced economies pair an elected fiscal authority with an independent mon-

etary authority. Replicating the advancedeconomies’ structure with author-

ities microfounded by a political economy model shows that this structure is

the solution to a constrained mechanism design problem that overcomestime

inconsistency and results in the highest possible welfare. Goal and instru-

ment independence, singly and in combination, are insufficient to minimize

time inconsistency, though their combination is necessary.

JEL codes: E52, E61, E63

Keywords: monetary independence, monetary fiscal policy interaction,

time inconsistency.

IN ADVANCED ECONOMIES,AN ELECTED fiscal authority is paired

with an independent monetary authority. While the monetary authority’s indepen-

dence takes many forms, there is no country that elects the monetary authority in the

same fashion as the fiscal authority.This paper examines the consequences of electing

the monetary authority using a macro model featuring political economy foundations

from Battaglini and Coate (2008). Earlier work, Miller (2016), has examined the

consequences of electing the fiscal authority. Jointly, these papers establish that sep-

arating an elected fiscal authority and an unelected, benevolent, monetary authority

is the unique structure of monetary and fiscal authorities that ameliorates the time

inconsistency problem of nominal debt, as in Kydland and Prescott (1977) and Barro

and Gordon (1983). This pairing results in the highest possible societal welfare by

allowing the use of nominal bonds for tax smoothing.

The main contribution of this paper is to refine ideas about monetary independence

using explicit microfoundations to evaluate possible structures for monetary and

The views expressed in this paper are those of the author and not necessarily those of the Federal

Reserve Board or of the Federal Reserve System.

DAVI D S. MILLER is at Federal Reserve Board (E-mail: david.s.miller@frb.gov).

Received July 2, 2018; and accepted in revised form December 17, 2018.

Journal of Money, Credit and Banking, Vol. 51, Nos. 2–3 (March–April 2019)

C

2019 The Ohio State University

290 :MONEY,CREDIT AND BANKING

Time inconsistency,

Bonds = 0,Bonds ≥0,

Instrument independence Goal, instrument indep.

Time inconsistency, Time inconsistency,

Bonds = 0,Bonds = 0,

Goal, instrument indep. Instrument independence

Elected

[This Paper]

Benevolent

[Miller (2016)]

ElectedBenevole nt

Monetary Authority

Fiscal Authority

FIG. 1. Choice of Monetary and Fiscal Structures.

fiscal authorities. Fischer (1994) describes two forms of independence for a mone-

tary authority: goal independence—a monetary authority may have different goals

than the fiscal authority—and instrument independence—a monetary authority may

have different instruments than the fiscal authority. Electing an authority in the man-

ner of Battaglini and Coate (2008) makes the authority’s goal maximizing the welfare

of a subset of the citizens rather than maximizing societal welfare. If the monetary

authority is elected, it may be goal and instrument independent from the fiscal au-

thority, but it will not be able to sustain nominal debt due to the self-interested desire

for inflation of the subset of citizens who elected it, even if overall, citizens would

prefer no inflation. Both types of independence are necessary, but not sufficient, to

overcome time inconsistency.

There are four possible structures for fiscal and monetary authority design: each

authority can be benevolent, with a goal is to maximize the welfare of all citizens, or

elected, and hence politically distorted, in the manner of Battaglini and Coate (2008),

with a goal to maximize only the welfare of citizens who voted for it. The structures

are illustrated in Figure 1. This paper examines the possibilities for the monetary

authority contained on the left-hand side of the figure. Miller (2016) examined the

possibilities for the monetary authority contained on the right-hand side of the figure.

Electing the monetary authority while keeping the fiscal authority benevolent,

despite featuring goal and instrument independence, does not alleviate time incon-

sistency. An elected monetary authority knows that inflating away the real value of

the bonds held by everyone will eliminate the real value of bonds held by the subset

of citizens who elected it. The logic of time inconsistency is identical to the classical

case where both authorities are benevolent. The elected monetary authority will in-

flate, eliminating the real wealth of its coalition, in order to have the fiscal authority

set distortionary taxes to their lowest level.

Electing both the fiscal and monetary authority (or equivalently, when fiscal au-

thority captures the monetary authority) also results in time inconsistency, but for

a different reason. The elected monetary authority will inflate, eliminating the real