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Interactions Between Monetary and Fiscal Policy under Flexible Exchange Rates

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  • Campbell Leith
  • Simon Wren-Lewis

Abstract

The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1995), under the heading of the ‘Fiscal Theory of the Price Level’ (FTPL). Applications of this theory to open economies operating under flexible exchange rates has suggested that, in contrast to the closed economy FTPL, insolvent fiscal policy may lead to indeterminacy of price levels and nominal exchange rates. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have independent monetary and fiscal policies. We show that the fiscal response required to ensure stability of the real debt stock, and allow each country to operate an ‘active’ inflation-targeting monetary policy is greater when consumers are not infinitely lived. One monetary authority can abandon its active targeting of inflation to stabilise the debt of another fiscal authority, and there is no requirement that these policy makers operate in the same economy. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when one or more monetary authority is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2002_11.

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Handle: RePEc:gla:glaewp:2002_11

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Keywords: Monetary Policy; Fiscal Policy; New Open Economy Macroeconomics; Fiscal Theory of the Price Level;

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References

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  1. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. Eleni Iliopulos & Marcus Miller, 2006. "Can Using Interest Rates to Check Domestic Demand Raise the Strength of the Sterling in the Long Run?," Documents de recherche 06-13, Centre d'Études des Politiques Économiques (EPEE), Université d'Evry Val d'Essonne.
  2. Ascari, Guido & Rankin, Neil, 2013. "The effectiveness of government debt for demand management: Sensitivity to monetary policy rules," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1544-1566.
  3. Jukka Railavo, 2004. "Effects of the supply-side channel on stabilisation properties of policy rules," Macroeconomics 0404028, EconWPA.
  4. Lieb Lenard, 2009. "Taking Real Rigidities Seriously: Implications for Optimal Policy Design in a Currency Union," Research Memorandum 032, Maastricht University, Maastricht Research School of Economics of Technology and Organization (METEOR).
  5. Mikek, Peter, 2008. "Alternative monetary policies and fiscal regime in new EU members," Economic Systems, Elsevier, vol. 32(4), pages 335-353, December.
  6. Campbell Leith & Simon Wren-Lewis, 2002. "Taylor Rules in the Open Economy," Discussion Papers 0203, Exeter University, Department of Economics.
  7. Railavo, Jukka, 2003. "Effects of the supply-side channel on stabilisation properties of policy rules," Research Discussion Papers 34/2003, Bank of Finland.
  8. Robert Ambrisko & Jan Babecky & Jakub Rysanek & Vilem Valenta, 2012. "Assessing the Impact of Fiscal Measures on the Czech Economy," Working Papers 2012/15, Czech National Bank, Research Department.
  9. Apostolis Philippopoulos & Petros Varthalitis & Vanghelis Vassilatos, 2012. "On the optimal mix of fiscal and monetary policy actions," Working Papers 150, Bank of Greece.
  10. Railavo , Jukka, 2004. "Stability consequences of fiscal policy rules," Research Discussion Papers 1/2004, Bank of Finland.
  11. Apostolis Philippopoulos & Petros Varthalitis & Vanghelis Vassilatos, 2013. "Optimal Fiscal Action in an Economy with Sovereign Premia and without Monetary Independence: An Application to Italy," CESifo Working Paper Series 4199, CESifo Group Munich.
  12. Linnemann, Ludger, 2006. "Interest rate policy, debt, and indeterminacy with distortionary taxation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(3), pages 487-510, March.
  13. Eleni Iliopulos & Marcus Miller, 2007. "UK External Imbalances and the Sterling: Are they on a Sustainable Path?," Open Economies Review, Springer, vol. 18(5), pages 539-557, November.
  14. Jukka Railavo, 2004. "Stability consequences of fiscal policy rules," Macroeconomics 0404020, EconWPA.

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