Monetary Policy Coordination and the Level of National Debt

• Published in: Empirica Vol. 27; no. 4; pp. 389 - 409
• Main Author: Pizzati, Lodovico
• Format: Journal Article
• Language: English
• Published: New York Springer 2000; Springer Nature B.V
• Series: Empirica
• Subjects: Bias; Central banks; Cooperation; Debt; Economic models; Economic policy; Economics; European Monetary Union; Exchange rates; Fixed exchange rates; Foreign exchange rates; Global economy; Inflation; Inflation Bias; Interest rates; Monetary policy; National Debt; Policy co-ordination; Propensity to consume; Studies; Taxes; Europe
• ISSN: 0340-8744; 1573-6911
• DOI: 10.1023/A:1010945530370

This paper uses the Canzoneri-Henderson benchmark framework of monetary policy coordination in interdependent economies to analyze how high levels of national debt affect monetary policy interactions. Using a two-country model, I first study how central banks interact in a flexible exchange-rate regime. I find that a low-debt country is better off interacting with a country with high debt, when both economies are affected by an aggregate inflationary shock. I also consider a political dependence scenario, in which central banks are subject to political pressure. In the case of a debt-burdened country, the political incentive to reduce interest payments on debt will spur a Gordon-Barro like inflation bias. However, under a flexible exchange-rate regime, the low-debt country will not be affected. Under a monetary union instead, political pressure may affect the low-debt country as well, and possibly create an inflation bias even greater than in the flexible exchange-rate regime. This scenario presents another example of how Rogoff's counterproductive monetary cooperation may arise under European Monetary Union. [PUBLICATION ABSTRACT]