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Time Inconsistency and Free-Riding in a Monetary Union

Authors

  • VARADARAJAN V. CHARI,

    1. Varadarajan V. Chari is the Paul W. Frenzel Land Grant Professor of Liberal Arts, Department of Economics, University of Minnesota, 4-101 Hanson Hall, 1925 Fourth Street South, Minneapolis, MN 55455, and a Consultant, Research Department, Federal Reserve Bank of Minneapolis, 90 Hennepin Avenue, Minneapolis, MN 55401-1804 (E-mail: chari@res.mpls.frb.fed.us).
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  • PATRICK J. KEHOE

    1. Patrick J. Kehoe is the Frenzel Professor of International Economics, Department of Economics, University of Minnesota, 4-101 Hanson Hall, 1925 Fourth Street South, Minneapolis, MN 55455, and a Monetary Advisor, Research Department, Federal Reserve Bank of Minneapolis, and Research Associate, National Bureau of Economic Research, 1050 Massachusetts Avenue, Cambridge, MA 02138-5398 (E-mail: pkehoe@res.mpls.frb.fed.us).
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  • The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

Abstract

In monetary unions, a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of non-monetary policies. The free-rider problem leads union members to pursue lax non-monetary policies that induce the monetary authority to generate high inflation. Free-riding can be mitigated by imposing constraints on non-monetary policies. Without a time inconsistency problem, the union has no free-rider problem; then constraints on non-monetary policies are unnecessary and possibly harmful. This theory is here detailed and applied to several non-monetary policies: labor market policy, fiscal policy, and bank regulation.

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