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This paper is a revised version of the first chapter of my Ph.D. dissertation. I would like to thank my thesis advisers Stanley Fischer and Rudi Dornbusch, as well as Peter Isard, David Laibson, Owen Lamont, Phil Lowe, Eric Schalling, Matt Slaughter and Stacey Tevlin, and participants in the MIT Macroeconomics Seminar for invaluable comments.
For a comprehensive survey of the existing theoretical and empirical literature, see Cukierman (1992).
Some exceptions are Sargent and Wallace (1981), Parkin (1986), Alesina and Tabellini (1987), and Masciandaro and Tabellini (1988). Petit (1989) examines the issue in a dynamic model with two policymakers and concludes that cooperation between the two is optimal. Beetsma and Bovenberg (1995) build on the analysis in this paper.
The central bank actually controls the money stock, which is assumed to map directly into the inflation rate as shown below.
Analytically, this is the same as a wage income tax.
w* may be explained by efficiency wage theories or an insider/outsider model. See the discussion in Alesina and Tabellini (1987) footnote 5, p. 621.
It is also assumed that the economy is on the left hand portion of the seigniorage Laffer curve. Beetsma and Bovenberg (1995) analyze the case where inflation does not map into seigniorage revenue one-for-one, but rather seigniorage is a fraction κ of inflation.
This is a sufficient condition.
The responsibility for debt repayment could also be interpreted as a commitment mechanism.