Commitment versus Discretion in a Political Economy Model of Fiscal and Monetary Policy Interaction

Price commitment results in lower welfare. I explore the consequences of price commitment by pairing an independent monetary authority issuing nominal bonds with a fiscal authority whose endogenous spending decisions are determined by a political economy model. Without price commitment, nominal bonds are backed by a new form of endogenous commitment that overcomes time inconsistency to make tax smoothing possible. With price commitment, nominal bonds will be used for both tax smoothing and wasteful spending. Price commitment eliminates monetary control over fiscal decisions. I show that the combination observed in advanced economies of a politically distorted fiscal authority and an independent monetary authority with nominal bonds and without price commitment is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest welfare.