Cross-country estimates of the degree of fiscal dominance and central bank independence

This paper studies the interdependence between fiscal and monetary policies, and their joint role in the determination of the aggregate price level. In general, fiscal and monetary policies are linked through the consolidated government budget constraint. A combination of taxes, new debt issue, and seigniorage revenue must finance government expenditures in every period. In terms of the intertemporal budget constraint, outstanding debt must be backed by a combination of the present discounted value of current and future primary surpluses and seigniorage revenues. More specifically, this paper investigates if the proportion of debt that is backed by each source of revenue, primary surplus or seigniorage, matters for the determination of the price level.

The theoretical analysis is carried out in a standard competitive monetary economy. The government is characterized by a long-run fiscal policy rule whereby a given fraction of the outstanding debt, say δ, is backed by the present discounted value of current and future primary surpluses. Theremaining debt is backed by seigniorage revenue. The parameter δ is structural and summarizes the degree of interdependence between fiscal and monetary authorities in a given institutional setup. It is shown that in a standard monetary economy, this policy rule implies that the price level depends not only on the money stock, but also on the proportion of debt that is backed with money.

This paper draws on earlier research by Aiyagari and Gertler (1985), extending their work in at least three directions. First, results are derived using only the long-run fiscal policy rule without having to specify a particular period-by-period rule. This long-run rule is compatible with the time-stationary rule in Aiyagari and Gertler, but also with other (perhaps not time-stationary) period-by-period rules. Second, the determination of the price level is characterized at all times, rather than only at the steady state. Finally, a simple empirical strategy is proposed to construct estimates of the δ parameter for a cross-country sample of developing and industrialized economies.