Independent Central Banks: Coordination Problems and Budget Deficits

Abstract

This paper develops a simple game-theoretic model to show how the independence of central banks can result in coordination problems with the fiscal authority and excessive budget deficits. In a Stackelberg equilibrium with the fiscal authority as leader, the budget deficit is optimal. In contrast, with the central bank as leader, the budget deficit is too high. While in a Nash equilibrium, the budget deficit is higher still.