Fiscal Policy and the Implementation of the Walsh Contract for Central Bankers

Abstract

We develop a simple macroeconomic model where the time inconsistency of optimal monetary policy is due to tax distortions. If fiscal policy is exogenously fixed at its optimal level, a Walsh contract (Walsh, 1995) offered to an independent central bank implements the optimal monetary policy. When fiscal policy is determined endogenously, however, this contract is subject to strategic manipulation by the government, which results in a suboptimal policy mix. Implementing the optimal policy mix requires either that the central bank enjoy primacy over the fiscal authority or that fiscal policy be also delegated to an independent authority.

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