Staff Report 308

Time Inconsistency and Free-Riding in a Monetary Union

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
V. V. Chari | Consultant

Revised April 1, 2008

We analyze the setting of monetary and nonmonetary policies in monetary unions. We show that in these unions a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of nonmonetary policies, such as labor market policy, fiscal policy, and bank regulation. The free-rider problem leads the union’s members to pursue lax nonmonetary policies that induce the monetary authority to generate high inflation. The free-rider problem can be mitigated by imposing constraints on the nonmonetary policies, like unionwide rules on labor market policy, debt constraints on members’ fiscal policy, and unionwide regulation of banks. When there is no time inconsistency problem, there is no free-rider problem, and constraints on nonmonetary policies are unnecessary and possibly harmful.

Published In: Journal of Money, Credit, and Banking (Vol. 40, No. 7, October 2008, pp. 1329-1355)

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