Monetary–fiscal policy interaction and fiscal inflation: A tale of three countries

We study the impact of the interaction between fiscal and monetary policy on the low-frequency relationship between the fiscal stance and inflation using cross-country data from 1965 to 1999. In a first step, we contrast the monetary–fiscal narrative for Germany, the U.S., and Italy with evidence obtained from simple regression models and a time-varying VAR. We find that the low-frequency relationship between the fiscal stance and inflation is low during periods of an independent central bank and responsible fiscal policy and more pronounced in times of non-responsible fiscal policy and accommodative monetary authorities. In a second step, we use an estimated DSGE model to interpret the low-frequency measure structurally and to illustrate the mechanisms through which fiscal actions affect inflation in the long run. The findings from the DSGE model suggest that switches in the monetary–fiscal policy interaction and accompanying variations in the propagation of structural shocks can well account for changes in the low-frequency relationship between the fiscal stance and inflation.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. 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 monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

Monetary–fiscal policy interactions and commitment versus discretion in a monetary union

We consider monetary–fiscal policy interactions in a monetary union. If monetary and fiscal authorities have different ideal output and inflation targets, the Nash equilibrium output or inflation or both are beyond the ideal points of all authorities. Leadership of either authority is better. Fiscal discretion entirely negates the advantage of monetary commitment: The optimal monetary rule is equivalent to discretionary leadership of monetary over fiscal policy. Agreement about ideal output and inflation creates a monetary–fiscal symbiosis, yielding the ideal point despite disagreement about the relative weights of the two objectives, for any order of moves, without fiscal co-ordination, and without monetary commitment.     

Monetary and Fiscal Management, Finance, and Growth

This paper addresses three related aspects of monetary and fiscal management in Europe and elsewhere. First, I discuss the implications of economic integration for monetary and fiscal policy, especially the narrow focus on low inflation as the main objective of monetary policy. I argue that because inflation springs from several sources, monetary authorities held responsible by law for maintaining low inflation need to exercise their newfound independence by reserving the right to address all sources of inflation. In this context, I also ponder the question as to whether the increased independence of fiscal policy from short-term political interference would be desirable. Second, I present new empirical evidence of the relationship between inflation, finance, and economic growth across countries, arguing that long-run growth considerations provide an important additional justification for why price stability ought to remain a priority of independent policy makers. Third, I review some further aspects of the relationship between fiscal policy and economic growth, emphasizing the traditional three-pronged role of fiscal management: stabilization, allocation, and distribution, all of which can be conducive to growth. The argument leads to the conclusion that only the stabilization function of fiscal policy and, perhaps, some aspects of the allocation function as well could be usefully delegated in an attempt to immunize them from shortsighted and socially counter-productive political interference, but not the distribution function.     

The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability

We study how constrained fiscal policy can affect macroeconomic stability and welfare in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government spending and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under some tax variability and constant regional inflations. We use a variety of rules to characterize constrained fiscal policy and find that strict fiscal rules coupled with a monetary policy that targets union-wide inflation result in regional inflation stability and the welfare costs of such rules are not as unbearable as one would expect. Fiscal authorities can enhance welfare by targeting the regional output gap, while targeting regional inflation is less successful since inflation stability is guaranteed by the central bank.     

Games of monetary and fiscal interactions in the EMU

This paper constructs various models of the EMU and ECB when member countries have different objectives. Voting in pursuit of national interest can yield moderate and stable inflation. The metaphor of Walsh-type contracts implements a monetary policy rule that averages the member countries’ most preferred rules. In a repeated relationship where a country suffering a large adverse shock can use political bargaining to subvert the ECB's commitment, the optimal rule should incorporate some flexibility to forestall that. Finally, freedom of national fiscal policies undermines the ECB's monetary commitment; this may justify fiscal constraints like the Stability and Growth Pact.     

MONETARY–FISCAL INTERACTIONS WITH A CONSERVATIVE CENTRAL BANK

We study macroeconomic stabilization when monetary and fiscal policies interact via their effects on output and inflation and the monetary authority is more conservative than the fiscal. We find that monetary–fiscal interactions result in poor macroeconomic stabilization. With both policies discretionary, the Nash equilibrium is suboptimal with higher output and lower inflation than optimal; the Nash equilibrium may be extreme with output higher and inflation lower than either authority want. Leadership equilibria are not second best. Monetary commitment is completely negated by fiscal discretion and yields the same outcome as discretionary monetary leadership for all realizations of shocks. But fiscal commitment is not similarly negated by monetary discretion. Optimal macroeconomic stabilization requires either commitment of both monetary and fiscal policies, or identical targets for both authorities – output socially optimal and inflation appropriately conservative – or complete separation of tasks.     

Inflation Targeting - the Holy Grail of Monetary Policy?

Inflation targeting is a statement about the objective of central bank policy and not about operating procedures. Its success depends not only on the actions of the central bank, but requires a broad consensus concerning the proper role of monetary policy in the economy. It also requires the backing of a sound fiscal policy. As countries differ both in economic structure and monetary transmission mechanism, the implementation of inflation targeting must be country specific. Instability over time in the transmission mechanism also implies that inflation targeting strategies must evolve to avoid the fate of previous monetary policy targeting practices.     

宏观调控与实体经济

我国当前的宏观经济面临通货膨胀和经济增长下行的双重压力,两者都会在实体经济上反映出来。针对通货膨胀应该高度关注并采取适度的宏观调控政策,但不能反应过度。现阶段的主要矛盾已经转到经济增长下行问题。宏观经济学的精髓在于均衡,合适的宏观政策应该是在保持经济增长和控制通货膨胀之间找到均衡,选择一个合适的均衡点。我国近期根据宏观经济的走势实施稳健的货币政策和积极的财政政策,意味着将会释放出数量较大的流动性,而这些流动性应该重点流向实体经济。有效的宏观调控必须是以市场化改革所形成的经济体制为基础的。不能因为宏观调控而放慢市场化改革的步伐,尤其要支持实体经济领域民营经济的发展。     

Stepping on a rake: The role of fiscal policy in the inflation of the 1970s

The inflation of the 1970s in the US is often discussed as if the only type of policy action that could have prevented the inflation were monetary policy actions and the only type of policy errors that might have induced the inflation were monetary policy errors. Yet fiscal policy underwent dramatic shifts in the 1970s and economic theory makes clear that in an environment of uncertainty about future fiscal policy, monetary policy instruments may lose potency or have perverse effects. This paper documents the vagaries of fiscal policy in this period and argues that people at the time must have been uncertain about fiscal policy's future course. It also lays out a theoretical framework for understanding the effects of fiscal uncertainties on monetary policy and shows that fiscal variables have predictive value in dynamic models, even if traditional monetary policy indicators are included in the system.     

Distortionary fiscal policy and monetary policy goals

We reconsider the role of an inflation conservative central banker in a setting with distortionary taxation. To do so, we assume monetary and fiscal policy are decided by independent authorities that do not abide to past commitments. If the two authorities make policy decisions simultaneously, inflation conservatism causes fiscal overspending. But if fiscal policy is determined before monetary policy, inflation conservatism imposes fiscal discipline. These results clarify that in our setting the value of inflation conservatism depends crucially on the timing of policy decisions.     

Multiple Wage Bargaining Systems in the Single European Currency Area

Little attention in the EMU literature has been paid to the interaction between centralbank monetary rules and systems of collective wage bargaining. Analytically andempirically, coordinated wage bargaining systems respond with real wage restraintto non-accommodating monetary policy. Since wage determination is dominated bycollective bargaining in all the EMU member states and wage coordination within themember states has grown since 1980, this is a topic of potential importance. In particular, the replacement of the Bundesbank, directly targeting German inflation, by an ECB targeting European inflation has removed a major institutional support of wage restraint in Germany. The consequences of this for EMU are worked out under two scenarios, that inflation expectations will be generated by ECB monetary policy and that they will reflect German inflation outcomes. Possible institutional developments are discussed including government-union bargains. The Bundesbank has also played a major role in maintaining fiscal rectitude by targeting excess fiscal deficits in Germany: again its replacement by the ECB – targeting (if at all) European rather than German fiscal policy – loosens fiscal constraints. For underlying structural reasons therefore, it is possible that Germany and other EMU countries will move to a period of fiscal activism with wage restraint and low inflation purchased through social contract negotiations.     

CONTROLLING INFLATION WITH TIMID MONETARY–FISCAL REGIME CHANGES

Can monetary policy control inflation when both monetary and fiscal policies change over time? When monetary policy is active, a long-run fiscal principle entails flexibility in fiscal policy that preserves determinacy even when deviating from passive fiscal, substantially for brief periods or timidly for prolonged periods. In order to guarantee a unique equilibrium, monetary and fiscal policies must coordinate not only within but also across regimes, and not simply on being active or passive, but also on their extent. The amplitude of deviations from the active monetary/passive fiscal benchmark determines whether a regime is Ricardian: Timid deviations do not imply wealth effects.     

Understanding policy in the great recession: Some unpleasant fiscal arithmetic

I use the valuation equation of government debt to understand fiscal and monetary policy in and following the great recession of 2008–2009. I also examine policy alternatives to avoid deflation, and how fiscal pressures might lead to inflation. I conclude that the central bank may be almost powerless to avoid deflation or inflation; that an eventual fiscal inflation can come well before large deficits or monetization are realized, and that it is likely to come with stagnation rather than a boom.     

Financial distress and fiscal inflation

Is inflation ‘always and everywhere a monetary phenomenon’ or is it fundamentally a fiscal phenomenon? The answer hinges crucially on the underlying monetary–fiscal policy regime. Scant attention has been directed to the role of credit market frictions in discerning the policy regime, despite its growing importance in empirical macroeconomics. We augment a standard monetary model to incorporate fiscal details and credit market imperfections. These ingredients allow for both interpretations of the inflation process in a financially constrained environment. We find that introducing financial frictions to the model and adding financial variables to the dataset generate important identifying restrictions on the observed pattern between inflation and measures of financial and fiscal stress, to the extent that it overturns existing findings about which monetary–fiscal policy regime produced the U.S. data. To confront policy regime uncertainty, we propose the use of dynamic prediction pools and find strong cyclical patterns in the estimated historical regime weights.     

Exchange rate regimes and inflation: only hard pegs make a difference

Abstract.  Using data from a large sample of developing countries from 1985 to 2001, we confirm that hard pegs (currency boards or a shared currency) reduce inflation and money growth. There is no evidence that soft pegs confer any monetary discipline, after other factors are controlled for. Inflation triggers regime switches. Under hard pegs, monetary growth is unaffected by fiscal deficits or by inflation shocks. Under soft pegs, as under floats, increased fiscal deficits and positive inflation shocks are associated with higher monetary growth. The apparently slower per capita output growth under hard pegs is explained by their geographical distribution. JEL classification: F41     

The reaction of disagreements in inflation expectations to fiscal sentiment obtained from information in official communiqués

Using official communiqués about fiscal policy, we develop a fiscal sentiment indicator, and we verify the reaction of disagreements in inflation expectations to fiscal sentiment. This analysis is relevant to inflation targeting (IT) countries because transparency and communication can influence expectations. The results suggest that a more optimistic fiscal sentiment reduces disagreements in inflation expectations. Estimates show that, for higher disagreements in inflation expectations at 12-month maturity, an optimistic fiscal sentiment can reduce the disagreement more sharply. In turn, the fiscal sentiment effect on the disagreement for the 48-month maturity is stronger the smaller the disagreement is. The results allow us to outline the following policy recommendations. First, an optimistic fiscal environment is important in the task of guiding inflation expectations and reducing inflation uncertainty. Second, fiscal communication is an important tool for the expectations formation process, and therefore it must be carefully managed to help in the task of forward guidance of inflation expectations, being important for the IT regime. Third, both fiscal credibility and monetary policy credibility are important for the expectations formation process, particularly for the reduction of inflation uncertainty, representing aspects that must be preserved in countries that adopt the IT regime.     

Deficit sustainability and inflation in EMU: An analysis from the Fiscal Theory of the Price Level

Price determination theory typically focuses on the role of monetary policy, while the role of fiscal policy is usually neglected. From a different point of view, the Fiscal Theory of the Price Level takes into account monetary and fiscal policy interactions and assumes that fiscal policy may determine the price level, even if monetary authorities pursue an inflation targeting strategy. In this paper we try to test empirically whether the time path of the government budget in EMU countries would have affected price level determination. Our results point to the sustainability of fiscal policy in all the EMU countries but Finland, although no firm conclusions can be drawn about the prevalence of either monetary or fiscal dominance.     

Interactions between Monetary and Fiscal Policy Rules

The Fiscal Stability Pact for EMU implies that constraints on fiscal policy facilitate inflation control. In this paper we identify two stable policy regimes. When monetary policy seeks to raise real interest rates in response to excess inflation, a self-stabilising fiscal policy is required to ensure model stability. A fiscal policy which does not, by itself, ensure fiscal solvency constrains monetary policy to be relatively 'passive'. However, in simulations we conclude that the central bank does not need to seek, on this account, the degree of debt stabilisation that appears to be implied by the fiscal stability pact.     

Monetary and fiscal policy interactions in a post Keynesian open-economy model

Using a post Keynesian model, this study aims to analyze the stabilizing role of fiscal and monetary policies in an open economy with a managed exchange rate regime. The real exchange rate is modeled as an endogenous variable and inflation explained using the conflicting claims approach. The dynamic properties of macroeconomic equilibrium are evaluated in different regimes of fiscal and monetary policies. The main result of this study suggests that the preferred policy regime is the one in which economic authorities are complementary and fiscal policy plays an explicitly active role. In this regime, the fiscal policy must commit to the target for the rate of capacity utilization and the monetary authority must commit to the inflation target.