Essays on Fiscal and Monetary Policy Interaction

This dissertation studies the interaction of fiscal and monetary policy. The first chapter establishes that price commitment results in lower welfare. I explore the consequences of price commitment by pairing an independent monetary authority issuing nominal bonds with a fiscal authority whose decisions are microfounded by a political economy model. The results show that the combination of a politically distorted fiscal authority and an independent monetary authority with nominal bonds and without price commitment is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest welfare. The second chapter extends the model used in the first chapter by allowing the fiscal authority to commit to policies. Endogenous commitment leads to the creation of a new monetary regime where fiscal policy forces the monetary authority to choose a specific price level. This regime is more likely in volatile times, when the level of nominal bonds is high or when the cost of inflation is low. When the new regime leads to different allocations than the conventional regime it will result in lower welfare.