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

Abstract

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.