A comparison of monetary and fiscal policy interaction under ‘sound’ and ‘functional’ finance regimes

The interest rate and the fiscal balance can be thought of as two independent instruments to be assigned to two targets, the path of output and the path of public debt. Under what we term a ‘sound finance rule’ the interest rate targets output while the fiscal balance targets public debt; under a ‘functional finance rule’ the budget balance targets the output gap and the interest rate targets the debt ratio. The same unique combination of interest rate and fiscal balance will be consistent with output at potential and a constant debt‐GDP ratio regardless of which instrument is assigned to which target. The stability characteristics of the two rules differ, however. At low levels of debt, both rules converge to the targets, but there is a threshold debt level above which only the functional finance rule converges. Contrary to conventional wisdom, therefore, the case for countercyclical fiscal policy becomes stronger, not weaker, when the ratio of public debt to GDP is already high. We apply our framework to describe the possibility of policy‐generated cycles in the United States over the past five decades.