Policy Games: Coordination and Independence in Monetary and Fiscal Policies

No ONE WOULD dream of designing the human anatomy by disconnecting the controls of the left and right sides of the body. Yet, for the most important economic controls in a modern economy, monetary and fiscal policies, economists today generally endorse the separation of powers as a way of optimizing noninflationary growth. What are the costs and benefits of coordination and independence in macroeconomic policy? What are the consequences of the independence in policymaking that has become firmly rooted in the American polity? Does policy independence lead to a bias in the mix of monetary and fiscal policies? These are the questions addressed in this study. One of the major implications of separated powers is seen in the mix of monetary and fiscal policies that is found in major countries today. Policymakers and economists in virtually all countries with separated monetary and fiscal policies believe that their countries suffer from fiscal deficits and real interest rates that are too high to promote a healthy level of private investment and adequate long-term growth of potential output. This syndrome of an unfavorable and undesirable monetary-fiscal mix has been a feature of the macroeconomic landscape for more than a decade. Although there are many explanations of this endemic skewness of the fiscal-monetary mix, this paper considers the possibility that decisionmakers are caught in an interaction that locks them into high deficits and tight money. Fiscal authorities are elected and are reluctant to set in