Debt targets and fiscal sustainability in an era of monetary independence

Abstract

This paper investigates how to achieve flexibility in fiscal policy without sacrificing credibility or independence in monetary policy. The idea is to create a framework that generates fewer conflicts between policies but greater discipline within them. We assume an independent central bank and restraints on national fiscal policies. Using a theoretical model, we examine the consequences of assigning leadership to fiscal policies in order to exploit the implicit (but rule based) coordination available under standard transmission mechanisms and to allow priorities and targets to differ between policy makers. This works best when leadership takes the form of a debt rule (with hard or soft targets) to precommit fiscal policies over the longer term; but monetary independence to guarantee the credibility and discipline in the short term policies. Compared to the uncoordinated policies operating in Europe, inflation biases and debt/deficit ratios are both lower for no loss in output volatility. That matches the experience of the UK, an economy whose empirical reaction functions show fiscal leadership. On a wider sample of Organization for Economic Cooperation and Development countries, the gains from debt targeting are estimated at 2–4% of gross domestic product.