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Monetary and Fiscal Policy in Times of Crisis: A New Keynesian Perspective in Continuous Time

Author

Listed:
  • Britta Förster
  • Bernd Hayo

Abstract

To analyse the interdependence between monetary and fiscal policy during a financial crisis, we develop an open†economy DSGE model with monetary and fiscal policy, as well as financial markets, in a continuous†time framework based on stochastic differential equations. Monetary policy is modelled using both a standard and a modified Taylor rule and fiscal policy is modelled as either expansionary or austere. In addition, we differentiate between open economies and monetary union members. We find evidence that the modified Taylor rule notably reduces the likelihood that the financial market crisis affects the real economy. However, if we assume that households are averse to outstanding government debt, we find that a combination of expansionary monetary policy and austerity†oriented fiscal policy does a better job of stabilising both domestic and foreign economies in regard to both output and inflation. In the case of a monetary union, we find that stabilization of output in the country where the financial shock originated is no longer as easy and, in terms of prices, there is now deflation in that country and a positive inflation rate in the other member country of the monetary union.

Suggested Citation

  • Britta Förster & Bernd Hayo, 2018. "Monetary and Fiscal Policy in Times of Crisis: A New Keynesian Perspective in Continuous Time," Manchester School, University of Manchester, vol. 86(1), pages 21-48, January.
    • Handle: RePEc:bla:manchs:v:86:y:2018:i:1:p:21-48
    DOI: 10.1111/manc.12173
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    Cited by:

    1. Shobande Olatunji Abdul, 2020. "Fiscal Rule in Africa," Open Economics, De Gruyter, vol. 3(1), pages 112-120, January.
    2. Joanna Stawska & Paulo Reis Mourao, 2025. "Policy mix under stress: review of economic reactions to fiscal and monetary policies using DSGE," Entrepreneurship and Sustainability Issues, VsI Entrepreneurship and Sustainability Center, vol. 12(4), pages 477-496, June.
    3. Shobande Olatunji Abdul, 2020. "Fiscal Rule in Africa," Open Economics, De Gruyter, vol. 3(1), pages 112-120, January.
    4. Shobande Olatunji Abdul & Shodipe Oladimeji Tomiwa, 2019. "New Keynesian Liquidity Trap and Conventional Fiscal Stance: An Estimated DSGE Model," Economics and Business, Sciendo, vol. 33(1), pages 152-169, January.

    More about this item

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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