Welfare Improving Coordination of Fiscal and Monetary Policy

The paper considers a simple model in which monetary and …scal policies are formally independent, but still interdependent through spillovers of macroeconomic outcomes. It shows that the average equilibrium levels of in‡ation, de…cit, debt, and output depend on the two policies’ (i) potency (elasticity of output with respect to the policy instruments); (ii) ambition (the level of their output target); and (iii) conservatism (the degree of in‡ation aversion). However, it is the relative degrees of these that matter rather than the absolute degrees for each policy. Therefore, coordination of monetary and …scal policy is found to be superior to non-cooperative Nash behaviour for both policymakers. Interestingly though, it is coordination in terms of the policies’ambition, rather than conservatism, that is essential. Furthermore, ambition-coordination may be welfare improving even if the policymakers’ objectives are idiosyncratic, and their coordinated output targets di¤er from the socially optimal one. Keywords: coordination, interaction, monetary policy, …scal policy, central bank, government, in‡ation, de…cit, debt. JEL classi…cation: E61, E63 We would like to thank ... for useful suggestions and comments. All errors and omissions are our own responsibility. Corresponding author: La Trobe University, School of Business, Melbourne, Victoria, 3086, Australia. Phone: +61 3 94792754, Email: [email protected].