The fiscal policy environment central banks operate in can be radically different with respect to debt levels, maturity structures and whether or not fiscal adjustments are spendingor tax-based. Despite this, most analyses of monetary policy delegation schemes typically ignore the behavior of the fiscal policy maker. This paper investigates whether delegating either nominal income or price level targets to a monetary authority yields social gains in an economy with government debt, where the fiscal policymaker, acting strategically, may support or undermine the policies of the central bank. We argue that the fiscal environment plays an important role in determining the performance of monetary policy. The gains to price level targeting typically found in the literature can be overturned at empirically relevant debt-to-GDP ratios, when debt stabilization is achieved through spending cuts. In contrast these gains are retained if the fiscal authorities utilize taxes to respond to shocks and stabilize debt.

The fiscal policy environment central banks operate in can be radically different with respect to debt levels, maturity structures and whether or not fiscal adjustments are spendingor tax-based. Despite this, most analyses of monetary policy delegation schemes typically ignore the behavior of the fiscal policy maker. This paper investigates whether delegating either nominal income or price level targets to a monetary authority yields social gains in an economy with government debt, where the fiscal policymaker, acting strategically, may support or undermine the policies of the central bank. We argue that the fiscal environment plays an important role in determining the performance of monetary policy. The gains to price level targeting typically found in the literature can be overturned at empirically relevant debt-to-GDP ratios, when debt stabilization is achieved through spending cuts. In contrast these gains are retained if the fiscal authorities utilize taxes to respond to shocks and stabilize debt.

Fiscal policies that stabilize debt may not provide the fiscal backing necessary for monetary policy to successfully target inflation. Appropriate backing is provided by passive fiscal behavior. Understanding the distinction between stabilizing and passive fiscal policies is central to the design of fiscal rules.

This paper studies discretionary non-cooperative monetary and fiscal policy stabilization in a New Keynesian model, where the fiscal policymaker uses a distortionary taxe as the policy instrument and operates with long periods between optimal time-consistent adjustments of the instrument. We demonstrate that longer fiscal cycles result in stronger complementarities between the optimal actions of the monetary and fiscal policymakers. When the fiscal cycle is not very long, the complementarities lead to expectation traps. However, with a sufficiently long fiscal cycle -one year in our model -no learnable time-consistent equilibrium exists. Constraining the fiscal policymaker in its actions may help to avoide these adverse effects.