Essays on Economics of Leviathan Monetary and Fiscal Policies

Date of Completion

January 2011

Keywords

Economics, General

Degree

Ph.D.

Abstract

At different times and in many countries, there has existed a close connection between fiscal and monetary policy. This may have been because of lack of sufficient tax revenues or specific situations like the current financial crises requiring such policy response. There is not much literature modeling this policy environment using a money search framework. This dissertation aims to bridge this gap by modifying a much often-used money search model to include a Leviathan or a utility maximizing central bank. The first essay studies the nature of optimal monetary policy of this monetary authority. The analysis suggests multiple outcomes with actual realization depending on context specific factors. For example, fiscal profligacy is associated with higher inflation- a fact borne out by many actual examples. The second essay evaluates a thought exercise in institutional design to control inflation in such a context. It extends the model in the first essay to create an environment with currency competition and shows that better inflation outcome is more likely in the case of Leviathan currency competition than in the single Leviathan bank case. The third essay looks at the fiscal side of the Leviathan policies. India is a good candidate for such a case study as fiscal deficits contribute significantly to monetary base and deficits of the state governments contribute to the total fiscal deficit. There are also substantial differences in political cohesiveness of state governments that could be influencing the level and composition of their spending. To analyze these aspects, we build a theoretical model explaining the choice of spending by a government as an outcome of equilibrium voting policies by agents in presence of negative income shocks amplified by credit constraints. The model's implications are then tested with data on 17 Indian states for the period of 20 years. There is substantial evidence that political cohesiveness affects the nature of spending and that credit constraints play a role in determining the likelihood of having a coalition government. Together, this dissertation forms a body of theoretical and empirical research shedding light on the effects of a typical fiscal and monetary policy environment. ^

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