We develop a model of monetary and fiscal policy where the time inconsistency of optimal monetary policy is due to the effects of tax distortions. If fiscal policy is exogenous, a Walsh (1995) contract offered to an independent central banker implements the optimal monetary and fiscal policies. Such a contract, however, is subject to strategic manipulation by the government when fiscal policy is made endogenous. As a result, a suboptimal Nash equilibrium emerges, in which distortionary taxation is too high while inflation is too low. Implementing the optimal policy mix would require that either (i) the central banker has primacy over the fiscal authority, or (ii) fiscal policy is delegated to an independent authority also subject to an "optimal" contract.
Download is not available
