Equilibria under ‘active’ and ‘passive’ monetary and fiscal policies

Monetary and fiscal policy interactions are studied in a stochastic maximizing model. Policy is ‘active’ or ‘passive’ depending on its responsiveness to government debt shocks. Schemes for financing deficits and, therefore, the existence and uniqueness of equilibria depend on two policy parameters. The model is used to: (i) characterize the equilibria implied by various financing schemes, (ii) derive policies where fiscal behavior determines how monetary shocks affect prices, and (iii) reinterpret Friedman’s 1948 policy framework. The paper reconsiders the result that prices are indeterminate when the nominal interest rate is pegged. The setup can be used to interpret reduced-form studies on fiscal financing.