Fiscal and Monetary Policy Interactions: Empirical Evidence and Optimal Policy Using a Structural New Keynesian Model

Abstract

This paper examines the interaction of monetary and fiscal policies using an estimated New Keynesian dynamic general equilibrium model for the US. In contrast to earlier work using VAR models, we show that the strategic complementarity or substitutability of fiscal and monetary policy depends crucially on the types of shocks hitting the economy, and on the assumptions made about the underlying structural model. We also demonstrate that countercyclical fiscal policy can be welfare-reducing if fiscal and monetary policy rules are inertial and not co-ordinated.