Independent Central Banks and the Interplay between Monetary and Fiscal Policy

Abstract

Monetary policy has fiscal implications that are especially pronounced at the zero lower bound. Independent central banks in advanced economies have considerable leeway to ease fiscal pressures faced by governments without compromising price stability. They also have the power to create unnecessary fiscal problems. A fiscal squeeze can serve as an incentive against a “misbehaving” government that appears reluctant to adopt the structural reforms that, in the central bank’s view, may be in the long-term interest of a country. Validating default fears and high risk premiums on government debt can be a potent tool to discourage what the central bank perceives as “moral hazard.” At times, independent central banks may be tempted to step outside their mandate and use their considerable discretionary authority to achieve what they perceive as better economic outcomes. How should this authority be used? Are the limits of democratic legitimacy respected? Comparing the recent policy records of the Bank of Japan and the European Central Bank suggests that independent central banks have not always managed to balance the inevitable tensions satisfactorily.