Bureaucratic corruption and the dynamic interaction between monetary and fiscal policy

Abstract

This paper analyses the dynamic interaction between monetary and fiscal policies in the presence of bureaucratic corruption. Corruption constrains the fiscal capacity to tax and increases the reliance on inflation (seigniorage). Given the restrictions that corruption imposes, a monetary reform strengthening central bank independence induces strategic debt accumulation; the government has the incentive to use debt and indirectly ‘force’ the central bank to pursue expansionary monetary policy. This result is augmented by the size of bureaucratic corruption, posing difficulties on the achievement of both a balanced debt process and price stability. The adverse implication of corruption on debt accumulation, given central bank independence, is supported in a large cross-sectional event study for developed and developing countries. Complementing the analysis with a measure for the level of independence each central bank reform enacted, the impact of corruption is greater, the higher the degree of independence granted. The results are also confirmed when accounting for countries that did not forego meaningful reforms and our findings are robust to different sub-samples, control variables and unobserved heterogeneity.