Debt stabilisation and dynamic interaction between monetary and fiscal policy: In medio stat virtus

Abstract

Recent literature has focused on studying how fiscal and monetary authorities in a monetary union can interact during a debt stabilisation process. This literature shows that only exogenous shocks or differences among countries determine deviations from the target level of macroeconomic variables in the steady state equilibrium. This paper aims to reformulate such modelling in a time setting, assuming that policy authorities do not coordinate and cannot perfectly predict the decisions made by their counterpart. This paper shows that simple decision processes driven by the best response mechanism or adaptive expectations do not guarantee convergence to steady-state equilibrium. Instead, persistent fluctuations in the level of macroeconomic variables and policy instruments may emerge if the relative weight given by the fiscal authority to the components of its objective function, namely, debt stability and output stability, is too unbalanced.