Inflation Targets and Debt Accumulation in a Monetary Union

This paper explores the interaction between centralized monetary policy and decentralized fiscal policy in a monetary union. Discretionary monetary policy suffers from a failure to commit. Moreover, decentralized fiscal policymakers impose externalities on each other through the influence of their debt policies on the common monetary policy. These imperfections can be alleviated by adopting state-contingent inflation targets (to combat the monetary policy commitment problem) and shock-contingent debt targets (to internalize the externalities due to decentralized fiscal policy).