CENTRAL BANK REPUTATION AND THE MONETIZATION OF DEFICITS: THE 1981 ITALIAN MONETARY REFORM

In 1981 the Bank of Italy was freed from the obligation to purchase the unsold public debt at the Treasury auctions. Since then, the Bank of Italy has reduced debt monetization. The paper seeks to explain this policy shift by analyzing a game between the monetary and fiscal authorities. The fiscal authority is imperfectly informed about the central bank preferences. An equilibrium exists in which the central bank does not monetize, so as to establish a reputation of being independent. Monetization raises fiscal deficits and may raise public debt relative to a non-accommodative policy.