Monetary-Fiscal Interactions with a Conservative Central Bank

Abstract 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.

Published in:
Scottish Journal of Political Economy, 53, 1, 90-128
JEL Classification codes: E61, E63

 Record created 2007-07-16, last modified 2018-03-17

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