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Welfare Improving Coordination of Fiscal and Monetary Policy

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Abstract

Should independent monetary and fiscal policies coordinate their actions and/or targets? To examine this question the paper considers a simple reduced-form model in which monetary and fiscal policies are formally independent, but still interdependent—through their mutual spillovers. The analysis shows that the medium-run equilibrium levels of inflation, deficit, and output depend on the two policies’ (i) potency (elasticity of output with respect to the policy instruments), (ii) ambition (the level of their output target), and (iii) conservatism (inflation vs. output volatility aversion). What matters is however the relative degrees of these characteristics across the two policies rather than the absolute degrees for each policy. This implies that coordination of monetary and fiscal policy is superior to non-cooperative Nash behaviour. In particular, we find that ambition-coordination is more important than conservatism-coordination in terms of avoiding medium-run imbalances due to a tug-of-war betw een the policies. For this reason, and perhaps surprisingly, ambition-coordination can be welfare improving even if the policymakers’ objectives are idiosyncratic, and their coordinated output targets differ from the socially optimal value.

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Bibliographic Info

Article provided by Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies in its journal AUCO Czech Economic Review.

Volume (Year): 5 (2011)
Issue (Month): 1 (March)
Pages: 007-026

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Handle: RePEc:fau:aucocz:au2011_007

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Keywords: Coordination; interaction; monetary policy; fiscal policy; central bank; government; inflation; deficit;

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  1. Demertzis, Maria & Hughes Hallett, Andrew & Viegi, Nicola, 2004. "An independent central bank faced with elected governments," European Journal of Political Economy, Elsevier, vol. 20(4), pages 907-922, November.
  2. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  3. Robert J. Barro & David B. Gordon, 1983. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  4. Jess Benhabib & Stefano Eusepi, 2005. "The design of monetary and fiscal policy: a global perspective," Proceedings, Federal Reserve Bank of San Francisco.
  5. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  6. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  7. Jan Libich & Andrew Hughes Hallett & Petr Stehlik, 2007. "Monetary And Fiscal Policy Interaction With Various Degrees And Types Of Commitment," CAMA Working Papers 2007-21, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  8. Aarle, B. van & Engwerda, J.C. & Plasmans, J.E.J., 2001. "Monetary and Fiscal Policy Interaction in the EMU: A Dynamic Game Approach," Open Access publications from Tilburg University urn:nbn:nl:ui:12-88307, Tilburg University.
  9. Andrew Hughes Hallett & Jan Libich, 2007. "Fiscal-monetary Interactions: The Effect of Fiscal Restraint and Public Monitoring on Central Bank Credibility," Open Economies Review, Springer, vol. 18(5), pages 559-576, November.
  10. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  11. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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