Bureaucratic Corruption and the Dynamic Interaction between Monetary and Fiscal Policy

Introduction The aim of this paper is to explore the impact of bureaucratic corruption on the interaction of monetary and fiscal policies under different levels of monetary authority independence. On atheoretical level, we readdress the time-inconsistency problem of monetary policy focusing on the driving forces of monetary and fiscalpolicymaking when the economy is faced with suboptimal institutional quality. The empirical analysis concentrates on the relationship between fiscal outcomes, and more precisely, debt accumulation and corruption after full or partial central bank independence (CBI) has been legislated. There has been a general and intensively increasing trend towards central bank inde- pendenceinthe past couple of decades among both industrial and developing countries. During late 1980s and early 1990smany industrial countries have strengthened or estab- lishedthe independent legal status of their central banks, and developing countries followed their example soon afterwards. In the same context, many countries have opted for an in- flationtargeting framework, assigning price stability as the primary objective. Nonetheless, the monetary and fiscal performance of these countries has been very divert. Bureaucratic corruption provides an explanation for these observed differences. Central bank independence has received considerable attent ion in both policy and aca- demiccircles. The main theoretical argument in favour of CBI, initiated by Barroand Gordon (1983), stresses the elimination of the time inconsistency problem of monetary policy; that is, the use of unanticipated monetary policy fora short-term boost of the economy. Hence, an independent central bank would'tie the hands'of the government and eliminate the inflation bias. With the recognition that the inflation bias is determined by the taxation policy and hence the financing structure of government spending (Alesinaand Tabellini 1987)1, the literature has also focused on the interactions among monetary and fiscal policy, byendogenising the latter. In this context, inflation also serves as a tool for government revenues (seignorage) and budgetary considerations play an important role in determining monetary policy. Among other things, quality of institutions can affect the government'sfiscaldecisions. In a recent paper, Huangand Wei (2005), incorporate bureaucratic corruption in the static Alesinaand Tabellini (1987) framework and show the implications of corruption in the tax collection mechanism on the fiscal and inturn monetary policymaking.download