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POLITICAL CONFLICT AND BARGAINING IN A NEW KEYNESIAN MODEL OF FISCAL STABILIZATION

Published online by Cambridge University Press:  17 January 2020

Francesca Flamini  and
Campbell Leith
Francesca Flamini
Affiliation:
University of Glasgow
Campbell Leith*
Affiliation:
University of Glasgow
*
Address correspondence to: Campbell Leith, Economics, University of Glasgow, Gilbert Scott Building, Glasgow, G12 8QQ, UK. e-mail: campbell.leith@glasgow.ac.uk.
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Abstract

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Recent work on optimal monetary and fiscal policy in New Keynesian models has tended to focus on policy set by an infinitely lived benevolent policy maker, often with access to a commitment technology. In this paper, we explore deviations from this ideal, by allowing (time-consistent) policy to be set by a process of bargaining between two political players with different weights on elements of the social welfare function. We characterize the (linear) Markov perfect equilibrium and, in a series of numerical examples, we explore the resultant policy response to shocks which cannot be perfectly offset with the available instruments due to their fiscal consequences. We find that, even although the players, on average, have the socially desirable objective function, the process of bargaining implies an outcome which deviates from the time-consistent policy chosen by the benevolent policy maker. Moreover, the range of instruments available mean that policy makers will bargain across the entire policy mix, sometimes implying outcomes which are quite different from those that would be chosen by a single policy maker. These policy outcomes depend crucially on the nature of the conflict and also the level of government debt.

Keywords

New Keynesian ModelGovernment DebtMonetary PolicyFiscal PolicyBargainingInvestmentRecursive OptimizationMarkov Perfect Equilibrium
Type
Articles
Information
Macroeconomic Dynamics , Volume 25 , Issue 8 , December 2021 , pp. 2128 - 2179
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted re-use, distribution, and reproduction in any medium, provided the original work is properly cited.
Copyright
© Cambridge University Press 2020

Footnotes

Francesca Flamini and Campbell Leith are grateful to the ESRC, Grant No.s RES 061-23-0084; and RES-156-25-003 and RES-062-23-1436, respectively, for financial assistance. We also thank the editor, two referees, Charles Nolan, Eric Leeper, Gerhard Sorger, and participants at SAET2019 in Ischia for helpful comments. All errors remain ours.

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