Monetary-Fiscal Games Under Political Uncertainty : The Role of Institutions

The paper examines how rules and institutions as well as the monetary-fiscal coordination setup impact welfare outcomes of a reform during uncertainty shocks. We define uncertainty shocks as sudden events that create ambiguity about future course of economic policies chosen by policy makers as well as the possible responses of economic agents to the new policies. We examine uncertainty within a framework of interaction between several institutional factors: (1) the scheme of coordination between monetary and fiscal authorities, (2) credibility and reputation of authorities and (3) the degree of dependence on discretionary measures as opposed to commitments. Through a game theoretic model, we show that: first, a reform implemented under fiscal dominance accompanied with dependence on discretionary measures result in worst welfare outcomes that are magnified when uncertainty parameters are involved. Second, in the case of central bank independence and immunity to fiscal concerns, reforms signal fiscal discipline and produce desired outcomes. Third, proper fiscal rules and commitments under a scheme of benevolent and coordinating authorities are second best during uncertainty shocks and relatively lessen undesired outcomes due to higher credibility and lower time inconsistency. The results offer important policy implications in developing countries with structural fiscal and monetary problems where hazards of fiscal dominance, reliance on politically-driven discretionary interventions and lacking efficient rules and institutions are magnified during spells of political crises and usually result in undesirable welfare gains