Decentralised Policies and Efficient Trade-Offs: An Essay on the Costs of Uncoordinated Fiscal and Monetary Policies

In many countries two decision-making institutions, the government and the central bank, manage fiscal and monetary policy separately. Such decentralization can lead to a change in the optimal inflation-output trade-off. In fact lack of cooperation can result in a change in the position of the trade-off curve, or a reversal in the slope of this trade-off, or even the total absence of any exploitable trade-off. In this paper the techniques of differential game theory are used to calculate the efficient inflation-output trade-off within a continuous-time econometric model of the Italian economy, in order to examine the differences in the 'policy possibility frontiers' which arise as the result of cooperative and of noncooperative decision-making. The results show that the outcomes obtained in the case of noncooperation are inferior to those under cooperation, and also impose a policy conflict which would not otherwise be present. Moreover the range of policy choices open to the policy-makers is reduced under noncooperation. The results indicate that efficiency gains are not the only reason for coordinating fiscal and monetary policies.