Money, debt and deficits in a dynamic game

Abstract

This paper analyzes a dynamic linear-quadratic game between the fiscal and monetary authorities. The equilibrium outcome of the game determines the time path of money creation, fiscal deficits and public debt. The game is solved for different equilibrium concepts. The equilibria are then compared and interpreted with reference to alternative institutional arrangements. The main results are: (i) Coordination increases the speed of adjustment towards the steady state and takes the steady state value of public debt closer to the desired target, (ii) Precommitments take the non-cooperative equilibrium closer to the coordinated outcome. (iii) Increasing the weight that each policymaker assigns to his own private objectives slows down the adjustment process, places more burden on the opponent, but has ambiguous effects on the steady state value of public debt.