Welfare improving coordination of fiscal and monetary policy

Author name: 
Hallet AH
Libich J
Stehlik P

The paper considers a simple model in which monetary and fiscal policies are formally independent, but still interdependent - through their spillovers onto the macroeconomic targets to which they are not primarilly assigned. It shows that the average equilibrium levels of inflation, deficit, debt, 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). However, it is the relative degrees of these characteristics that matter, rather than the absolute degrees for each policy. Therefore, and as expected, coordination of monetary and fiscal policy is found to be superior to non-cooperative Nash behaviour for both policymakers. Interestingly though, it is coordination in terms of the policies’ambition, rather than conservatism, that is essential. That is a new result. Furthermore, ambition-coordination can be welfare improving even if the policymakers’objectives are idiosyncratic, and/or even their coordinated output targets differ from the socially optimal one.

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