Coordination of monetary and fiscal policies: A fresh look at the issue

Abstract

Summary A large literature has studied the coordination of monetary and fiscal policies in the context of macroeconomic stabilization. The general result from this literature is that coordination is desirable but that the welfare gains which can be achieved from it are negligible. In this paper, we take a fresh look at the issue. We consider coordination in the context of the longer-term orientation of monetary and fiscal policies and, hence, their impact on the economy’s steady state. We present a dynamic game, in which a fiscal authority sets its budgetary targets while the monetary authority sets its inflation target, and study the interaction between the two. We find that policy externalities between the two authorities are potentially large. Excessive central bank conservatism leads to high levels of public debt and reduced welfare. This speaks in favor of coordination in the sense that the institutional design of the central bank should be devised taking into account the characteristics of the fiscal authority.

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