In this paper we develop a traditional, theoretical, monetary policy game to investigate the (potential) linkages between credit expansion, inflation and inflation expectations. In particular, following the relevant literature, we capture the effects of credit expansion on inflation and how central bank losses are affected.

The links between credit expansion and the real economy have been extensively studied in the literature. For example, Mishkin (2007) argues that the better the functioning of credit systems is, the higher the alleviation of external financing constraints that hamper credit expansion and thus the growth of firms.

In our model, the central bank is assumed to be independent and the central banker to be 'conservative', in the sense of being more averse to inflation vis-á-vis the government and the rest of society (Rogoff, 1985). We show that, as the optimal level of credit expansion can affect the level of inflation, it also determines the level of the central banker's 'conservativeness'.

In this context, the government may find an incentive to create short-term positive output shocks through overzealous credit expansion, undermining the role of the central banker, given the limited potentials that monetary tools provide for offsetting such measures.

In this context, we explore whether there are societal benefits in delegating public debt management to an independent fiscal authority. Through this analysis we offer some insights on alternative institutional designs, on the complexity of interactions, and the welfare effects.

References

Mishkin, F.S. (2007). The Economics of Money and Financial Markets, Pearson/Addison Wesley.

Rogoff, K. (1985). The optimal degree of commitment to an intermediate monetary target. The Quarterly Journal of Economics 100(4), 1169–1189.