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The Monetary-Fiscal Policy Mix: Perspectives from the U.S
Abstract
This paper discusses the U.S. perspective on the monetary-fiscal policy mix, and the interactions between monetary and fiscal policy more broadly. It identifies three sets of issues that have been modeled in the theoretical literature: compo- sition effects, the implications of fiscal solvency, and problems stemming from coordination failures and strategic interactions. Empirical work presented in the paper indicates that fiscal and monetary policy appear to have had effects on the composition of output, but solvency, coordination and strategic issues have been neither significant nor endemic. In addition, there is no evidence of a systematic Federal Reserve response to fiscal policy, beyond that which would be implied by the impact of fiscal policy on future GDP growth.
... The various analysis show that the combinations of economic policies are depending on the total level of aggregate demand that can be influenced by the fiscal policy, the monetary policy and their combination. Studies from Kuttner (2002) or from Stiglitz (2007) attribute a major role for the central bank in maintaining macroeconomic stability in the country to the insufficient flexibility of a fiscal policy as a stabilisation tool. In models like Kuttner (2002), a fiscal policy is assumed to produce a demand shock that should be offset by the monetary authorities. ...
... Studies from Kuttner (2002) or from Stiglitz (2007) attribute a major role for the central bank in maintaining macroeconomic stability in the country to the insufficient flexibility of a fiscal policy as a stabilisation tool. In models like Kuttner (2002), a fiscal policy is assumed to produce a demand shock that should be offset by the monetary authorities. ...
... In 2000, the ECB raised the main interest rate from the level of 3% to 4.75%. In 2001, as a result of the economic slowdown (real GDP growth in the EZ in 2001 amounted to 1.4% and in 2002 to 0.8%), uncertainty in financial markets and falling HICP inflation (2.4% in 2001 and 2.2% in 2002), the ECB lowered its main refinancing operations rate from 4.75% at the beginning of 2001 to 2.75% at the end of 2002 (Annual Reports ECB 2001, 2002. That is why the subsequent years, i.e., 2003-2005, (Table 4) Now, we are going to comment on the perceived differences in monetary policy options based on the short-term interest rate. ...
Our aim is to identify periods of restrictive versus expansionary economic policy in the euro area in the last two decades. We firstly conducted the study for identifying the dominant trend in fiscal policies and then in monetary policies. We studied several fiscal outputs, focusing on the cyclical adjusted primary balance. We also analysed the European long-term and short-term interest rates. The study was conducted for several windows, namely for 3-, 4- and 5-year periods. Additional procedures were conducted for robustness checks, namely the study of structural breaks in the analysed time series as well as a study of them recurring to Markov-Switching Regimes models. For most of the analysed periods and subperiods of the series, we concluded for the presence of expansionary policies either in the fiscal or in monetary European domains. Finally, the results and the analysis of dependencies in the euro area economy favour the evidence that economic authorities in the euro area have sought to coordinate monetary and fiscal policy to stabilise the economy.
... Przesłanki koordynacji polityki pieniężnej i fiskalnej Problem współzależności między polityką banku centralnego i polityką fiskalną nie jest rzeczą nową. W ekonomii pierwszych trzydziestu powojennych lat kwestię odpowiedniego wyboru policy mix, rozumianego jako kombinacja polityki pieniężnej i fiskalnej, rozpa- trywano jednak raczej w kontekście wpływu na poziom zagregowanego popytu (Kuttner 2003) Niewiele uwagi poświęcano zaś wpływowi relacji między polityką pieniężną i fi- skalną na poziom cen. Uznawano, ze policy mix jest sama w sobie obojętna, zgodnie z tzw. ...
... Politykę skoordynowaną utożsamiano więc ze wzajemną spójnością polityki pieniężnej i fiskalnej, gwarantującą osiągnięcie założonego celu (por. Blinder 1982, Kuttner 2003. Takie definiowanie koordynacji poszczególnych dziedzin polityki gospodarczej wydaje się jednak niewystarczające. ...
... Powstało bardzo wiele modeli teoretycznych, badających impli- kacje wzajemnego oddziaływania władz fiskalnych i monetarnych. Całość tych interakcji Kuttner (2003) dzieli na trzy obszary, mianowicie na interakcje związane ze strukturą fi- nalnego popytu i produkcji, interakcje związane z międzyokresowym ograniczeniem bu- dżetowym oraz interakcje strategiczne, wywołane różnicami celów i preferencji między niezależnym decydentami, odpowiedzialnymi za politykę pieniężną i fiskalną. Dla pozio- mu cen istotne są zwłaszcza dwa ostatnie obszary współzależności. ...
PL
Wzajemne zależności między polityką pieniężną i fiskalną oraz ich wpływ na stabilność cen stanowią przedmiot rozważań zawartych w niniejszym artykule. Autor podejmuje próbę wskazania na możliwość zastosowania teorii gier do badania koordynacji obu tych typów polityki i formułuje wnioski, waloryzujące modele poszczególnych gier.
EN
Since the beginning of the 1980s, interactions of monetary and fiscal policy have been revisited and carefully analysed. Due to growing importance of price stability and problems with achieving it, special attention has been paid to the coordination of monetary and fiscal policy. Such coordination has been treated as crucial to a stable level of prices. Common method for considering these issues is game theory. The paper has two aims: to survey game theory in the context of monetary-fiscal interactions and to draw conclusions from specific games between the central bank and the government. First, I describe premises of coordination. Second, I bring closer basic concepts of game theory. Third I characterise chosen models of monetary-fiscal games. Then, I asses usefulness of game-theory approach in analysing economic policy and present conclusions, which monetary-fiscal games bring for the policy coordination. (original abstrac
... We will use a simple aggregate demand and supply (AD/AS) models to characterize the cyclicality of monetary and fiscal policies based on the framework in Kuttner (2016). Aggregate spending in the open economy is: ...
... The conflicts may arise from the different objectives of both authorities and their mutual independent decisions. This can be analyzed by using a game theoretic framework, and the qualitative implications of conflict monetary-fiscal game are similar to those that were discussed in Nordhaus (1994), Dixit and Lambertini (2013) and Kuttner (2016). ...
... We can explain it based on a theoretical model. We will use Kuttner's (2016) version of Nordhaus (1994). ...
This paper examines the interaction between monetary and fiscal policies. Using annual panel data covering the period from 1991 to 2016 for 42 countries, it characterizes the cyclical behavior of monetary and fiscal policy, distinguishing countries by institutional characteristics and policy frameworks. It also applies heterogeneous structural panel VAR methodology to quarterly data from a subset of these countries to assess the response to aggregate demand shocks. The main finding is that central bank independence and inflation targeting are associated with more countercyclical monetary and fiscal policies and an increased degree of coordination between the two.
... 6 Recent advances in time series methodologies, such as cointegration, VAR and VECMs, are currently very popular. Kuttner (2002) employed a quatrovariate VAR model that included GDP, inflation, the r ff , and a fiscal variable, which measured either with the actual government surplus or the structural primary balance. Kuttner found that both fiscal variables are informative in predicting GDP 7 . ...
... Kuttner found that both fiscal variables are informative in predicting GDP 7 . Kuttner (2002) also found that fiscal policy does not affect the r ff ; this finding allowed him to conclude that US monetary policy was conducted without constraint from fiscal policy. ...
... These statistical tests suggest that the Fed does not react to any short-run changes in any one of the three variables. The finding that r ff is not Granger caused by td is also supported by Kuttner (2002) who found that fiscal policy does not affect r ff . We conclude that US monetary policy during the sample period of 1955-2006 was exercised without constraint by fiscal policy. ...
This study investigates the effectiveness of monetary and fiscal policies in the US by employing cointegration and a quatrovariate Vector Error Correction Model together with Granger causality tests. Two models are estimated: (i) nominal national income, the ten-year government bond yield, and two policy variables, the federal government deficit and the federal funds rate; (ii) real national income, and the other same three variables. Monetary and fiscal policies are jointly ineffective in influencing nominal national income. However, monetary and fiscal policies are jointly effective in influencing real national income. In contrast to the first model, only monetary policy was found to be reactive to changes in real national income and the long-term interest rate. The asymmetric responses of the two policies to changes in real economic activity are attributed to the fact that monetary policy is much more efficient in promptly responding to changes in economic conditions than fiscal policy.
... The different objectives (and/or preferences) of the central bank and the government pose a challenge in the area of stabilising a country's economy. The optimal solution would be for the authorities to coordinate their actions and decisions, as coordination improves the situation of both decision-makers (Kuttner, 2002;Pindyck, 1976;Ribe, 1980). The greater the discrepancy between the preferences of the central bank and the government, the less favourable the policy mix is. ...
... 6. Similar to Bennett and Loayza (2000) and Kuttner (2002). 7. ...
The objective of this paper is to consider the cooperative game between the central bank and the government in the case of a non-euro country in the European Union or another country in the world that conducts an independent monetary policy and where statutory deficit restrictions were imposed on its budget. The study takes into account two independent players – the government and the central bank – that make autonomous decisions and are responsible for fiscal and monetary policy, respectively. Our mathematical policy mix model is based on the assumption that there exists some level of coordination between these policies. The article aims to analyse how the level of cooperation influences the behaviour of decision-makers in a specific policy mix model. As a result, the government taking into account the central bank’s goals has no impact on the equilibrium of the budget deficit and interest rates. The conclusion about the central bank’s privileged position emerged as a mathematical consequence of the proposed model. This is confirmed by another case where the government does not consider the central bank’s target in its decisions; then, it does not prevent the monetary authorities from influencing the Nash equilibrium level of either decision variable.
... The monetary -fiscal interactions and their implications are examined using models based on the game theory (Bennett, Loayza, 2001, p. 66). K. Kuttner (2002) emphasizes that the coordination of fiscal and monetary policies strongly influences economy and at the same time they are interrelated. Analysis of the models based on game theory indicates that the coordination of these policies would be beneficial for the economy. ...
... Many studies attribute the significant role of the central bank, for example, US Federal Reserve in maintaining macroeconomic stability in the country to the insufficient flexibility of a fiscal policy as a stabilization tool. In the neo-Keynesian models a fiscal policy is assumed to produce a demand shock that should be offset by the monetary authorities (Kuttner, 2002). ...
Decisions taken by the economic authorities within the monetary and fiscal
policy influence each other and thus affect the economy of a given country. The
literature on the subject indicates that it is essential for the economy that the monetary
and fiscal authorities cooperate with each other. However, such coordination of
actions of economic authorities is not easy to achieve because the central bank seeks to
ensure price stability, while the government strives to maintain high economic growth
and a low unemployment rate. In addition, it should be emphasized that the decisions
of economic authorities are made at various stages of the business cycle, which may
also affect a degree of coordination of monetary and fiscal policy (policy mix). The
aim of the article is to identify the relationship between economic variables in the
monetary and fiscal policy and thus variables describing the economy in Poland in
2000 - 2018. Particular attention is paid to the following economic variables: GDP per
capita, unemployment rate, General Government debt and deficit, investment rate, the
main interest rate of the central bank or inflation. The article verifies the hypothesis
that variables from the monetary and fiscal policy statistically significantly interact
with each other and thus influence the economic variables in Poland. The research
methods were based on statistical analyzes. The contribution of this article consists in
presenting a role of monetary and fiscal policy in influencing the Polish economy in
the years 2000 - 2018.
... In the economic literature is the concept of policy mix, understood as a combination of fiscal and monetary policy. Kuttner (2002) analyzing the monetary -fiscal interactions underlined the strategic interactions based on different goals and preferences of the independent authorities responsible for the conduct of monetary and fiscal policies. Economists, Sargent and Wallace (1981) developed the "theory of unpleasant monetarist arithmetic‖ based on the idea that at the time of occurrence of the dominance of fiscal, monetary authorities are no longer able to keep inflation under control, regardless of the strategy to use. ...
... Economists, Sargent and Wallace (1981) developed the "theory of unpleasant monetarist arithmetic‖ based on the idea that at the time of occurrence of the dominance of fiscal, monetary authorities are no longer able to keep inflation under control, regardless of the strategy to use. Kuttner (2002) also showed that taking into account the interactions associated with intertemporal budget constraint thought that the form of financing the budget deficit can be a money issue, bonds or a combination of both. It was thought that the bond issue does not lead to an increase in the price level, which is not true, because at the time to take account of rational expectations, it appears that the bond issue may also have inflationary consequences. ...
... This is because of the nature of the conflict between the central bank and the government, where the central bank pursues output and inflation levels lower than those set by the government. As a result, an inflationary fiscal policy is partially offset by an overly-contractionary monetary policy (Kuttner, 2002). ...
... The Lucas (1976) critique suggests that if we want to predict the effect of a policy experiment, we should model the deep parameters (relating to preferences, technology, and resource constraints) that are assumed to govern individual behavior, or so-called microfoundations. 3. Similar to Kuttner (2002) and Bennett and Loayza (2000). 4. As in Davig and Leeper (2011). ...
The importance of the central bank and the government conducting their policies has increased recently, with more attention being given to the effectiveness of policy mix. The non-cooperative models of the monetary and fiscal game are frequently employed to study interactions between both authorities. The models assume that the authorities take into account each other’s choices when making decisions. It is also important to remember when seeking equilibrium in the non-cooperative models that in the Nash Equilibrium (which is sought in this study) the parties try to come up with the best response to the opponent’s decision. The aim of the paper is to present the Nash Equilibrium in a non-cooperative game between the government and the central bank using a non-cooperative model of a fiscal-monetary game (a policy-mix MODEL). This study demonstrates that in the Nash Equilibrium in the model, the budget deficit and interest rate of an EU member state depend on the exogenous data (external to the model), such as inflation target, base inflation and the Maastricht deficit limit. This study is enhanced by an analysis of the government and central bank’s sensitivity to the deep parameters of economic variables.
... In the economic literature is the concept of policy mix, understood as a combination of fiscal and monetary policy. K. Kuttner (2002) analyzing the monetary -fiscal interactions underlined the strategic interactions based on different goals and preferences of the independent authorities responsible for the conduct of monetary and fiscal policies. Economists, T.J. Sargent and N. Wallace (1981) developed the "theory of unpleasant monetarist arithmetic" based on the idea that at the time of occurrence of the dominance of fiscal, monetary authorities are no longer able to keep inflation under control, regardless of the strategy to use. ...
... Economists, T.J. Sargent and N. Wallace (1981) developed the "theory of unpleasant monetarist arithmetic" based on the idea that at the time of occurrence of the dominance of fiscal, monetary authorities are no longer able to keep inflation under control, regardless of the strategy to use. K. Kuttner (2002) also showed that taking into account the interactions associated with intertemporal budget constraint thought that the form of financing the budget deficit can be a money issue, bonds or a combination of both. It was thought that the bond issue does not lead to an increase in the price level, which is not true, because at the time to take account of rational expectations, it appears that the bond issue may also have inflationary consequences. ...
The study presents the impact of monetary-fiscal policy mix on economic growth, mainly for the investments of euro area in financial crisis. Fiscal policy and monetary policy play an important role in the economy, influencing each other and on a number of economic variables as well. In the face of the recent financial crisis, which turned into a debt crisis, fiscal and monetary authorities have been working together to revive economic activity. There was a significant economic impact on the level of government investments. The central bank kept interest rates at very low levels and used nonstandard instruments of monetary policy. Fiscal authorities have increased government spending to stimulate investment and economic recovery. The paper concludes that the management of the fiscal and monetary authorities in a crisis situation has been modified compared to the period before the crisis, when the coordination of these policies was clearly weaker.
... This problem was raised inSachs and Larrain, 1993. 28 Financial stability is discussed inKiedrowska and Marszałek (2002a, 2002b, 2003.29 Moreover, price stability which, as it has been shown, coordination is conducive to, is perceived as a precondition of fi nancial stability. ...
To achieve price stability, coordination of monetary and fiscal polices is required. The importance of coordination results from such premises as understanding the interdependence between monetary and fiscal policy, the role of central bank independence, the instruments-targets relation and financial stability as well. The lack of coordination will result in inferior overall economic performance, whereas providing it will give a better outcome for both policymakers. Therefore, coordination may be treated as the necessary condition for achieving price stability. (original abstract)
... Policy mix is also often the subject of many works on State's strategies aimed at stimulating or stabilizing the economy of a given country. Kuttner (2002) notes that the overall level of aggregate demand may be shaped by monetary policy, fiscal policy, or a combination of both. Coordinated decisions of the government and the central bank may have a significant positive impact on the economic development of the country by stabilizing economic conditions and improving economic indicators. ...
ABSTRACT
The importance of the decisions made by central banks and governments has been increasing recently, especially in the EU countries. The relationships between short-term interest rates,
inflation rates, and public deficits have not been thoroughly described in the literature concerning the recent European cases. It is worth observing how the relationships between the key variables in
the field of monetary and fiscal policy behave in various groups of countries, e.g. in countries with low/high General Government deficits or in countries with low high public debt. The aim of the article is to empirically analyse the relationship between interest rates, inflation rates, and public deficits in European countries in the years between 1996–2019. We studied the relationships between interest rates, inflation rates, and public deficits. We turned to dynamic panel data
methods (two-step system GMM). First, interest rates and inflation rates have been related following the Taylor-rule direction across the European economies. Second, we have also found a positive relationship between inflation rates and public deficits, but reverting the postulated Sargent and Wallace (1981) hypothesis of seigniorage. Third, deficit and inflation rates have positive relations across European observations but more significantly in the cases of high deficits or with highly indebted economies.
... One of the reasons is that fiscal dominance has not been a serious issue, at least during the period of our study, or does not have a conflict between the issue of divergent policy goals(Kuttner, 2002). ...
This paper investigates whether monetary policies in Malaysia, Thailand and Singapore are best represented by either the Taylor rule or the augmented Taylor rule. It finds that the augmented Taylor rule, which incorporates the exchange rate and government spending, best represents monetary policies in these countries. The results show that past inflation and the output gap play a role in the monetary policy reaction function in Malaysia and Thailand. The results further show a strong preference towards interest rate smoothing, government spending, and the exchange rate by the central banks.
... The IMD Report takes into account the following factors: economic growth, employment, foreign trade results, price level, fiscal policy, company efficiency or infrastructure. 11 Table 1 presents the position of Poland in two selected rankings (GCI and IMD) within the years 2000 -2016. The position of Poland in selected rankings (excluding very high positions in 2000 in both rankings) shows a positive trend (despite the decline in some years). ...
The aim of the article is to characterise selected macroeconomic indicators from the policy mix area in the context of the competitiveness of the Polish economy. In order to achieve this aim, the following research methods are used: a review of the literature and statistical analysis method. The study includes an analysis of macroeconomic data for the years 2000-2016 on the policy mix and the competitiveness of the Polish economy. The results of the conducted analysis indicate that in the discussed period there was a statistically significant correlation between monetary and fiscal policy indicators in the background of improving indicators measuring the competitiveness of the Polish economy.
... national income per capita, unemployment, economic performance, fiscal policy and monetary policy). Hence, profitable macroeconomic parameters and economic policy are often considered factors contributing to the competitiveness of a given country 10 . For example, the World Economic Forum publishes a ranking of global competitiveness. ...
The aim of the article is to characterise selected macroeconomic indicators from the policy mix area in the context of the competitiveness of the Polish economy. In order to achieve this aim, the following research methods are used: a review of the literature and statistical analysis method. The study includes an analysis of macroeconomic data for the years 2000-2016 on the policy mix and the competitiveness of the Polish economy. The results of the conducted analysis indicate that in the discussed period there was a statistically significant correlation between monetary and fiscal policy indicators in the background of improving indicators measuring the competitiveness of the Polish economy.
... W pierwszych trzydziestu latach po drugiej wojnie światowej wpływowi relacji występujących między polityką pieniężną i polityką fiskalną na poziom cen poświęcano niewiele uwagi [Kuttner 2002]. Kwestię odpowiedniego wyboru policy mix badano głównie w kontekście jej oddziaływania na poziom zagregowanego popytu. ...
Poszukując teorii wyjaśniającej kształtowanie się poziomu cen i procesy inflacyjne, jako alternatywę dla ilościowej teorii pieniądza coraz częściej rozważa się fiskalną teorię poziomu cen (FTPL). Zgodnie z nią poziom cen jest określany przez międzyokresowe ograniczenie budżetowe, a inflacja jest zawsze zjawiskiem fiskalnym.
Zwolennicy FTPL przyjmują, że uwzględnienie miedzyokresowego ograniczenia budżetu rządu i założenie tzw. niericardiańskiej polityki fiskalnej pozwalają jednoznacznie określić poziom cen. W FTPL wyróżnia się dwa nurty, pierwszy dotyczy określoności poziomu cen, a drugi obejmuje kwestie związane z polityką gospodarczą i zaleceniami pod adresem decydentów. Ważnym wnioskiem FTPL jest to, że nawet w pełni niezależny bank centralny nie jest w stanie zapewnić stabilności poziomu cen.
FTPL ukazuje w zupełnie nowym świetle interakcje polityki pieniężnej i polityki fiskalnej. Ze względu na swój daleki od ortodoksyjnego charakter, FTPL stała się przedmiotem ożywionej krytyki.
One of the topics discussed among economic theorists is the attainment of coordination in the execution of monetary and financial policies by the government and the central bank. The government aims to foster robust economic growth through fiscal measures, while the central bank aims to maintain inflation stability through interest rate mechanisms. Therefore, in this study, the interaction between these two authorities was investigated in the framework of game theory in normal form. To establish equilibrium in this game, three equilibrium concepts are used: Nash equilibrium, Berge equilibrium and greedy scaler equilibrium. In Nash case, each player individually and self-interestedly seeks to maximize his profit. Conversely, in Berge equilibrium, players exhibit altruistic behaviors towards their opponents. Moreover, in greedy equilibrium, players engage in a semi-cooperative game, striving to advance their shared interests through the formation of coalitions. The outcomes of this game reveal that in a two-strategy situation, the Nash equilibrium occurs when both the government and the central bank adopt contractionary policy strategies. In this game, the economy does not enter into the prisoner's dilemma, but it is the Pareto optimal. Conversely, in the Berge equilibrium, the scenario arises where the government pursues an expansionary fiscal policy strategy while the central bank implements a contractionary monetary policy strategy. On the other hand, many situations of greedy equilibrium include both Nash and Berge equilibrium, and it shows the importance of semi-cooperative game between two authorities. In the following, the game with three design strategies and the results have been analysed, and at the end, some policy suggestions have been presented.
global financial crisis has cast doubt on existing within the mainstream economics consensus on monetary policy. So called ‘New Consensus Monetary Policy ’appeared to lack many important operational, political and institutional issues, especially with regard to consistency of the monetary-fiscal policy mix within the eurozone, as well as with reference to policy mix in the individual member countries. When crisis emerged,problems with monetary-fiscal coordination turned to be more complicated. The crisis has proved also inefficiency of the“one size fits all”monetary policy, implemented by the ECB. The divergences of Economic performance, business cycles,and financial development – all attending the financialisation proces –have become eye striking among the EMU members. Extremely low inflation rates have brought new challenges into focus resulting i.a. from the zero bound on nominal short-term interest rates. Taking this into consideration, the aim of this paper is to investigate the ways in which the monetary and financial policies of the ECB can be conducted in a low interest rates environment. Undertaken analysis allows for understanding the strengths and weaknesses of these policies. It also creates a background forformulatin galternative policy proposals aimed at dealing with divergence and disparities between EU member countries.
The aim of the paper is to compare the sensitivity of a government’s fiscal policy and a central bank’s monetary policy, which are in Nash equilibrium in the case of a non-cooperative game between the government and the central bank in Czechia, Hungary, and Romania. The analysis for each country is conducted from the date of its accession to the European Union. The research period for Czechia and Hungary includes the quarters 2004Q2-2019Q2, and for Romania, 2007Q1-2019Q2. The study has demonstrated that in Romania the government’s response to interest rate changes is the strongest and the central bank’s response to changes in the budget deficit turned out to be the weakest. On the other hand, the strongest response of the central bank to changes in the budget deficit turned out to be in Hungary, which means that the central bank in Hungary makes a significant correction of interest rates as a result of changes in the budget deficit.
The aim of this article is to present the essence of policy mix and the extraordinary actions undertaken by the monetary and fiscal authorities in Poland in response to the recent financial crisis. In the article, the hypothesis has been put forward that the challenges faced by monetary and fiscal authorities have contributed to carrying out coordinated actions, especially in support of economic growth during the recent financial crisis. As a result, in Poland during the last financial crisis, it seemed to observe greater cooperation between monetary and fiscal authorities.
We develop a simple macroeconomic model where the time inconsistency of optimal monetary policy is due to tax distortions. If fiscal policy is exogenously fixed at its optimal level, a Walsh contract (Walsh, 1995) offered to an independent central bank implements the optimal monetary policy. When fiscal policy is determined endogenously, however, this contract is subject to strategic manipulation by the government, which results in a suboptimal policy mix. Implementing the optimal policy mix requires either that the central bank enjoy primacy over the fiscal authority or that fiscal policy be also delegated to an independent authority.
We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker's
appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In
particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected
inflation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium
properties of inflation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing.
Natural-rate models suggest that the systematic parts of monetary policy will not have important consequences for the business cycle. Nevertheless, we often observe high and variable rates of monetary growth, and a tendency for monetary authorities to pursue countercyclical policies. This behavior is shown to be consistent with a rational expectations equilibrium in a discretionary environment where the policymaker pursues a "reasonable" objective, but where precommitments on monetary growth are precluded. At each point in time, the policymaker optimizes subject to given inflationary expectations, which determine a Phillips Curve-type tradeoff between monetary growth/inflation and unemployment. Inflationary expectations are formed with the knowledge that policymakers will be in this situation. Accordingly, equilibrium excludes systematic deviations between actual and expected inflation, which means that the equilibrium unemployment rate ends up independent of "policy" in our model. However, the equilibrium rates of monetary growth/inflation depend on various parameters, including the slope of the Phillips Curve, the costs attached to unemployment versus inflation, and the level of the natural unemployment rate. The monetary authority determines an average inflation rate that is "excessive," and also tends to behave countercyclically. Outcomes are shown to improve if a costlessly operating rule is implemented in order to precomrnit future policy choices in the appropriate manner. The value of these precommitments -- that is, of long-term agreements between the government and the private sector -- underlies the argument for rules over discretion. Discretion is the sub-set of rules that provides no guarantees about the government's future behavior.
Can the Federal Reserve or the European Central Bank (ECB) be held responsible for price stability, regardless of how fiscal policy is conducted? Is legal independence sufficient to allow central banks to carry out their mandates? Or, must legal independence be bolstered by constraints on fiscal policy? The Delors Report (1987) provided a blueprint for European Economic and Monetary Union (EMU) and argued that constraints were necessary, and the European Union codi- fied limits on deficits in the Stability and Growth Pact (SGP) of 1997. In the United States, federal balanced budget amendments have been proposed, but the arguments for them have not been as closely tied to central bank independence. The academic literature lends some sup- port to the notion that fiscal discipline is necessary for price stability; Michael Woodford (2001), in his money, credit, and banking lecture, asserts that "a central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is determined." In this paper, we describe the fiscal discipline that the recent litera- ture suggests is necessary for central bank independence, and we dis- cuss the price—in terms of foregone fiscal stabilization—at which the required discipline can be obtained. We argue that the United States and the European Union (EU) probably have the discipline that is required, that the Federal Reserve and the ECB probably do not need the protec- tive shield of a SGP or a balanced budget amendment, and that the
We introduce deep habits into a sticky-price sticky-wage economy and examine the resulting models ability to account for the impact of monetary policy shocks. The deep habits mechanism gives rise to countercyclical markup movements even when prices are flexible and interacts with nominal rigidities in interesting ways. Key parameters are estimated using a limited information approach. The deep habits model can account very precisely for the persistent impact of monetary policy shocks on aggregate consumption and for both the price puzzle and inflation persistence. A key insight is that the deep habits mechanism and nominal rigidities are complementary: the deep habits model can account for the dynamic effects of monetary policy shock at low to moderate levels of nominal rigidities. The results are shown to be stable over time and not caused by monetary policy changes.
This paper argues that the "fiscal theory of the price level" (FTPL) has feet of clay. The source of the problem is a fundamental "economic" misspecification. The FTPL confuses two key building blocks of a model of a market economy: budget constraints, which must be satisfied identically, and market clearing or equilibrium conditions. The FTPL asssumes that the government"s intertemporal budget constraint needs to be satisfied only "in equilibrium". This economic misspecification has far--reaching implications for the mathematical properties of the equilibria supported by models that impose the structure of the FTPL. It produces a rash of contradictions and anomalies. Copyright 2002 Royal Economic Society
Peach discusses the role of the fiscal rules introduced in the United States at the federal level from the mid-80s. He notes that the first generation of rules, which focused on numerical targets for the deficit, did not prove very effective. The second generation was more successful: it established ceilings on some expenditure items and modified budgetary procedures. In particular, changes in the tax code and in expenditure enacted in a session of the Congress were expected to be deficit neutral over a certain number of years. Peach argues that rules, although not always adhered to, substantially affected the policy debate in the United States. Rules were particularly effective when they were supported by the political will to avoid large deficits and debts. He notes that also simple rules can be instrumental in improving the fiscal balance. In particular, the requirement to formally raise the debt ceiling introduced in the US in 1917 contributed to the enactment of legislation aimed at avoiding debt expansion. He concludes that rules are particularly effective when the majority of voters are convinced that compliance with them is in their interest.
This paper explores the peculiar credibility problem that a zero bound on the short-term nominal interest rate, the liquidity trap, poses to monetary and Þscal policy. We present a rational expectations model in which the zero bound on short-term nominal interest rates is binding due to deßationary shocks. When the zero bound is binding the Central Bank best achieves its objectives by generating inßation expectations to lower the real rate of interest and stimulate aggregate demand. A discretionary Central Bank that is independent from Þscal policy, however, cannot credibly commit to inßation. The result is a liquidity trap that is characterized by excessive deßation and a negative output gap. This "deßation bias" is the opposite of the "inßation bias" analyzed by Barro/Gordon (1983) and Kydland/Prescott (1977). Turning to Þscal policy, our model implies that if the Central Bank is independent then Ricardian equivalence holds and deÞcit spending, i.e. tax cuts and debt accumulation, has no effect. Our proposed solution involves reducing the independence of the Central Bank. If Þscal and monetary policies are coordinated, Ricardian Equivalence fails, and the government can credibly commit to future inßation by deÞcit spending. As a result it lowers the real rate of return, curbs deßation and increases output. Finally we address what coordination of Þscal and monetary policy might entail in practice. We review the applicability of our model to the current situation in Japan. We then discuss the extent to which the successful policies pursued in Japan during the Great Depression can be rationalized by our model.
Since the mid 1980s, an extensive empirical literature has examined the relationship between U.S. Fiscal Deficits, exchange rates, and trade balances. We investigate two questions that continue to spark debate: do increased government deficits cause dollar appreciation, and do fiscal deficits lead to higher trade deficits (the popular ‘twin deficit’ notion)? We examine these issues fusing a five-variable VAR system, generating posterior probability bounds to assess significance. Our result provide some evidence that growing government deficits appreciate the dollar, and support the “twin deficit” notion that government deficits contribute to trade deficits.
We consider the interaction between monetary and fiscal policies, in one country and in a monetary union. In a Nash equilibrium, at least one of the outcomes (output and inflation) are more extreme than the ideal points of both policy authorities. We allow very general stochastic shocks to the parameters, and find the fully optimal monetary policy rule as a nonlinear function of these shocks. We find that the rule does no better than discretionary leadership of monetary policy in every realization of the shocks.
Against all odds, the euro turned out to be a weak currency. We argue that this outcome can readily be explained by the policy-mix that was chosen at the onset of the period: tight fiscal policies following the convergence mechanism that was imposed by the Maastricht treaty and loose monetary policy that resulted from the convergence of interest rates to the lower point of the spectrum. We investigate this outcome empirically and show that the euro's weakness can be understood as the result of an excess supply in the zone, which is channelled abroad in the usual beggar my neighbor way.
How do governments react to the accumulation of debt? Do they take corrective measures, or do they let the debt grow? Whereas
standard time series tests cannot reject a unit root in the U. S. debt-GDP ratio, this paper provides evidence of corrective
action: the U. S. primary surplus is an increasing function of the debt-GDP ratio. The debt-GDP ratio displays mean-reversion
if one controls for war-time spending and for cyclical fluctuations. The positive response of the primary surplus to changes
in debt also shows that U. S. fiscal policy is satisfying an intertemporal budget constraint.
Society can sometimes make itself better off by appointing a central banker who does not share the social objective function,
but instead places “too large” a weight on inflation-rate stabilization relative to employment stabilization. Although having
such an agent head the central bank reduces the time-consistent rate of inflation, it suboptimally raises the variance of
employment when supply shocks are large. Using an envelope theorem, we show that the ideal agent places a large, but finite,
weight on inflation. The analysis also provides a new framework for choosing among alternative intermediate monetary targets.
This paper uses the historical record to isolate episodes in which there were large monetary disturbances not caused by output fluctuations. It then tests whether these monetary changes have important real effects. The central part of the paper is a study of postwar U.S. monetary history. We identify six episodes in which the Federal Reserve in effect decided to attempt to create a recession to reduce inflation. We find that a shift to anti-inflationary policy led, on average, to a rise in the unemployment rate of two percentage points, and that this effect is highly statistically significant and robust to a variety of changes in specification. We reach three other major conclusions. First, the real effects of these monetary disturbances are highly persistent. Second, the six shocks that we identify account for a considerable fraction of postwar economic fluctuations. And third, evidence from the interwar era also suggests that monetary disturbances have large real effects.
The prevailing view of the economic consequences of financing government deficits, as reflected in the recent economics literature and in recent public policy debates, reflects serious misunderstandings. Debt-financed deficits need not "crowd out" any private investment, and may even "crowd in" some. Using a model including three assets - money, government bonds, and real capital - the analysis in this paper shows that the direction of the portfolio effect of bond issuing on private investment depends on the relative substitutabilities among these three assets in the public's aggregate portfolio. Since the all-important substitutabilities that make the difference between "crowding out" and "crowding in" are determined in part by the government's choice of debt instrument for financing the deficit, this analysis points to the potential importance of a policy tool that public policy discussion has largely neglected for over a decade - debt management policy. When monetary policy is non-accommodative, within limits debt management policy can take its place in augmenting the potency of fiscal policy, or in improving the trade-off between short-run stimulation and investment for long-run growth.
In his presidential address to the American Economic Association (AEA), Milton Friedman (1968) warned not to expect too much from monetary policy. In particular, Friedman argued that monetary policy could not permanently influence the levels of real output, unemployment, or real rates of return on securities. However, Friedman did assert that a monetary authority could exert substantial control over the inflation rate, especially in the long run. The purpose of this paper is to argue that, even in an economy that satisfies monetarist assumptions, if monetary policy is interpreted as open market operations, then Friedman’s list of the things that monetary policy cannot permanently control may have to be expanded to include inflation.
The authors show that the interest rate on Federal funds is extremely informative about future movements of real macroeconomic variables. Then they argue that the reason for this forecasting success is that the funds rate sensitively records shocks to the supply of bank reserves; that is, the funds rate is a good indicator of monetary policy actions. Finally, using innovations to the funds rate as a measure of changes in policy, the authors present evidence consistent with the view that monetary policy works at least in part through "credit" (i.e., bank loans) as well as through "money" (i.e., bank deposits). Copyright 1992 by American Economic Association.
The problem of time inconsistency arises from two different sources. First, as shown by Guillermo A. Calvo (1978), the re is an incentive for each government to engage in an initial unanti cipated inflation. Second, as discussed by Robert E. Lucas and Nancy L. Stokey (1983), there is an incentive for each government to deviat e from the path of taxes announced by the preceding government. In th is paper, it is shown that these two sources of time inconsistency ca n be removed by a particular method of debt management, involving bot h nominal and indexed government bonds of various maturities. Copyright 1987 by The Econometric Society.
Maintaining price stability requires not only commitment to an appropriate monetary policy rule, but an appropriate fiscal policy rule as well. Ricardian equivalence does not imply that fiscal policy is irrelevant, except in the case of a certain class of policies ("Ricardian" policies). The role of fiscal developments in inflation determination under a non-Ricardian regime is illustrated through an analysis of the bond-price support regime of the 1940s. A monetary-fiscal regime with attractive properties would combine a "Taylor rule" for monetary policy with nominal-deficit targeting as a fiscal policy commitment. # O#cial text of the 2000 Money, Credit and Banking Lecture, presented at Ohio State University on May 1, 2000. I wish to thank Michael Bordo, Matt Canzoneri, Steve Cecchetti, Larry Christiano, John Cochrane, Paul Evans, Eduardo Loyo, Bennett McCallum, Helene Rey, Stephanie Schmitt-Grohe and Chris Sims for helpful discussions, Gauti Eggertsson for research assistance...
Monetary Policy Implications of Greater Fiscal Discipline. Pages 151-70 of: Budget Deficits and Debt: Issues and Options
- John B Taylor
Taylor, John B. 1995. Monetary Policy Implications of Greater Fiscal Discipline. Pages
151-70 of: Budget Deficits and Debt: Issues and Options, Proceedings from a
symposium sponsored by the Federal Reserve Bank of Kansas City.
Macroeconomics, Fifth Edition
- Rudiger Dornbusch
- Stanley Fischer
Dornbusch, Rudiger, & Fischer, Stanley. 1990. Macroeconomics, Fifth Edition.
McGraw-Hill.
The Effects of Deficit Reduction Laws on Real Interest Rates. Board of Governors of the Federal Reserve System, FEDS Working Paper
- Douglas W Elmendorf
Elmendorf, Douglas W. 1996. The Effects of Deficit Reduction Laws on Real Interest
Rates. Board of Governors of the Federal Reserve System, FEDS Working Paper
#1996-44.