Working Paper Series no. 855: The Central Bank, the Treasury, or the Market: Which One Determines the Price Level?

This paper describes the game played by a fiscal authority aiming at spending as much as it can and a monetary authority targeting a certain price-level path. The link between the two authorities is that both authorities dislike, to some extent, government default. The objective of the paper is to provide for conditions under which one authority imposes its views on the other authority. This non-technical summary wraps up the main results of the paper.

We first consider a two-date game and then extend it to more dates. Compared to the literature, we crucially assume that both fiscal and monetary authorities play cannot commit on future policies. The monetary authority issues reserves, set interest on reserves and can use a part of the proceeds to buyback the bonds issued by the government. The fiscal authority issues debt, can default on past debt, and consumes. The price level is the price of goods in term of reserves.

The price level may depend on the net nominal public liabilities. We say that there is fiscal dominance when the fiscal authority imposes its views on monetary authority – when the monetary authority deviates from its price-stability objective to ensure the sustainability of public debt. Our first result is that, at the end of the game, fiscal dominance prevails when the public liabilities in the hand of the private sector exceeds the real public resources. When net public liabilities are sufficiently low, the monetary dominance prevails. When net public liabilities are so high that the price level required to make debt sustainable exceeds the monetary authority is ready to tolerate to avoid default, the monetary authority prefers letting the government default. Figure below shows the relationship between the price level at the terminal date and the net public liabilities.

Fiscal dominance only appears once all fiscal capacity is exhausted. If the government cannot commit unlike Sargent and Wallace (1981), the central bank can resist and avoid fiscal dominance as long as fiscal authority can raise revenues. So fiscal dominance, as the one in the middle region of the above figure, occurs when net public liabilities exceed the real resources of the public sector times the price target of the central bank. In this case, the central bank deviates from its objective and makes any action required to get the minimum price level that ensures sovereign solvency. Fiscal dominance thus requires that fiscal authority have no more fiscal space.

Exhausting fiscal capacity may be costly for the fiscal authority: it requires allocating spending over time in a specific (possibly suboptimal) way and it leaves little room to absorb new macroeconomic shock. The paper explores the first type of costs only. When choosing its optimal debt issuance policy, the fiscal authority should hence tradeoff the cost of over-borrowing and the potential gains from inflation. Fiscal authority will not deliberately choose fiscal dominance if the allocative costs dominate the gains from reduced debt burden due to inflation. The paper shows that this is the case when legacy nominal liabilities are small, the fiscal authority is more patient, future fiscal resources are large, real rates are responsive to public debt.

How can the monetary authority attenuate the cost of fiscal dominance? When legacy debt is huge, fiscal dominance is inevitable as real resources are insufficient to repay legacy debt with prices on target. In some cases, monetary authority can attenuate the cost of fiscal dominance by moderately raising inflation preemptively. By doing so, the monetary authority reduces the incentives for the fiscal authority to engage into a fiscal dominance strategy.

When debt repays itself due to dynamic inefficiency. In this case, a share of public debt may be unbacked by future primary surpluses. This share is however fragile and depends on self-fulfilling beliefs about the future private demand for the public debt. In such a context, the private sector can prick the bubble if disappointed by some public sector decisions, giving them an exorbitant privilege. In such an environment, the private sector, through out-of-equilibrium threats, determines who wins the game of chicken leading to what we call market dominance. Fiscal and monetary dominance may prevail depending on the off-equilibrium private sector strategy.