Tracking Monetary-Fiscal Interactions across Time and Space

The long-term fiscal outlook of most high-income countries is grim. Should independent central bankers be afraid of an unpleasant monetarist arithmetic, i.e., fiscal imbalances spilling over to monetary policy and jeopardizing price stability? To provide some insights, this paper tracks the interactions between fiscal and monetary policies in the data since 1980 for Australia, Canada, Japan, Switzerland, the United Kingdom, and the United States. In doing so it uses a combination of time-varying parameter vector autoregression with sign, magnitude, and contemporaneous restrictions identification. Unlike conventional approaches, this can capture changes in monetary and fiscal behavior that are gradual and differ across the two policies. Our results show that in the United States the degree of monetary policy accommodation of fiscal shocks (debt-financed government spending) increased gradually between the late 1980s and the 2008 crisis, i.e., over the whole tenure of Chairman Greenspan. In contrast, it seems to have decreased over this period in the United Kingdom, Australia, Switzerland, and Canada. Our benchmark analysis and several robustness checks show that legislating numerical inflation targets may account for some of the country differences, presumably because they may shift the strategic power from fiscal to monetary policy. We conclude by considering the implications of our results for the long-term likelihood of an unpleasant monetarist arithmetic in the six countries.