Debt stabilisation and dynamic interaction between monetary authority and national fiscal authorities

Abstract

The main aim of the present research is to consider a monetary union's economy consisting of N countries, N fiscal authorities (one for each country) and a single monetary authority. The fiscal authorities want to stabilise output and public debt through the primary government balance, and they can exhibit heterogeneous preferences about the trade-off between output and debt stability. Unlike these, the monetary authority has the aim of price and output stability. They play a non-cooperative policy game, in which they independently and simultaneously choose monetary and fiscal instruments to pursue their goals. In a dynamic setting, each authority must choose its policy instrument prevailing in the next period without knowing-at the end of each period-the choice of other authorities. By assuming static expectations, the present work shows the possibility of several dynamic outcomes. First, there exists one Nash equilibrium representing the optimal level for the macro economy; this equilibrium is stable if the average weight that fiscal authorities assign to output stability is not excessively high; therefore, this result holds even if some authorities are less willing to promote debt stabilisation. Second, in addition to this equilibrium, there exist other Nash equilibria representing steady-state values for macroeconomic variables that differ from the targets adopted by the authorities; these equilibria emerge and are stable if the authorities' preference for output stability is even greater and with a higher degree of heterogeneity compared to the previous case. Third, the parameters of the model matter to determine the stability properties of the equilibria, and the analysis shows the possibility of nonlinear dynamics.