DP17407 The Central Bank, the Treasury, or the Market: Which One Determines the Price Level?
This paper studies a political-economy model in which the price level is the outcome of dynamic strategic interactions between a fiscal authority, a monetary authority, and investors in government bonds and reserves. The 'unpleasant monetarist arithmetic', whereby aggressive fiscal expansion forces the monetary authority to chicken out and to lose control of inflation, occurs only if the public sector lacks fiscal space, in the sense that public debt along the optimal fiscal path gets sufficiently close to the threshold above which the fiscal authority would find default
optimal. Otherwise, monetary dominance prevails even though the central bank has neither commitment power nor fiscal backing.