Modelling Monetary and Fiscal Policy in the US: A Cointegration Approach

As governments and economists worldwide reflect on the unprecedented peacetime build-ups of government deficits and debts since 2008 and the Great Recession, the importance of fiscal and monetary policy interactions and their sustainability is key. This involves both thorough theoretical and careful econometric analysis. This paper provides the latter. We use multivariate cointegration methods to investigate monetary and fiscal interactions using the example of the United States since the early 1980s. Using survey data for inflation expectations, we find that monetary policymaking is heavily forward looking, and passive in the sense that it responds to policy rule. Fiscal policy is found to be active in that it does not respond to the fiscal policy rule discovered in the data. Entering into debates on the efficacy of fiscal policy, we find that in the long-term fiscal deficits are very harmful to growth, but in the short run fiscal stimuli can be effective in restoring the economy to equilibrium. The interactions between the two policy spheres appear somewhat limted in that neither policy tool enters the policy rule of the other policy sphere, but the more passive monetary policy does movwe in reaction to fiscal policy movements - the two policy spheres are complementary in that both respond in the same direction to revive and restrain the economy in downturns and boom times respectively.