Book Description

This thesis investigates the design of appropriate institutions to ensure the good conduct of fiscal and monetary policy. The three chapters develop theoretical frameworks to address the time-inconsistency of policy plans or prevent the occurrence of self-fulfilling prophecies. Time-inconsistency refers to a situation where preferences over policy change over time. Optimal policy plans are not credible, since agents anticipate the implementation of another policy in the future. This issue is particularly pervasive to monetary policy, since nominal quantities (price level, interest rates, etc.) are very sensitive to expected policies, but predetermined to actual policy choices. The first chapter investigates how fiscal policy can mitigate the inflation bias of monetary policy in an economy with heterogeneous agents. Whenever there is a desire for redistribution, progressive fiscal helps to implement a policy mix less biased toward inflation. Importantly, even the richest supports some fiscal progressivity, since over their life cycle, they benefit from a more balanced policy-mix. A self-fulfilling prophecy, or coordination failure, refers to a situation where a more desirable economic outcome could be reached, but fail to be, by the only effect of pessimistic expectations. Self-fulfilling debt crises are a classical example: pessimistic investors bid down the price of debt, which increases the likelihood of default, which in turn justifies the initial decrease in price. The second chapter, co-authored with Russell Cooper, asks whether monetary policy can deter self-fulfilling debt crises. The analysis shows how a counter-cyclical inflation policy with commitment is effective in doing so. Importantly, it can be implemented without endangering the primary objective of monetary policy, to deliver an inflation target for instance. The third chapter, co-authored with Andrew Gimber, revisits the classic Laffer curve coordination failure: taxes could be low, but they are high because agents anticipate high tax rates. In a dynamic environment with debt issuance, the multiplicity of equilibria critically depends on inherited debt. At high levels of public debt, fiscal policy is pro-cyclical: taxes increase when output decreases, and self-fulfilling fiscal crisis can occur. Overall, this chapter sheds light on the perils of high level of public debt.