Government and Central Bank Interaction under uncertainty: A Differential Games Approach

Today, debt stabilization in an uncertain environment is an important issue. In particular, the question how fiscal and monetary authorities should deal with this uncertainty is very important. Especially for some developing countries such as Iran, in which on average 60 percent of government revenues comes from oil, and consequently uncertainty about oil prices has a large effect on budget planning, this is an important question. For this reason, we extend in this paper the well-known debt stabilization game introduced by Tabellini (1986). We incorporate deterministic noise into that framework. We solve this extended game under a Non-cooperative, Cooperative and Stackelberg setting assuming a feedback information structure. The main result shows that under all three
regimes, more active policies are used to track debt to its equilibrium level and this equilibrium level becomes smaller, the more fiscal and monetary authorities are concerned about noise. Furthermore, the best-response policy configuration if policymakers are confronted with uncertainty seems to depend on the level of anticipated uncertainty.