Interactions between monetary and fiscal policy under flexible exchange rates

Abstract

We examine fiscal and monetary policy interactions by developing a two-country open-economy model under flexible exchange rates, where overlapping generations of consumers supply labour to imperfectly competitive firms that change their prices infrequently. We show in this context that the implications of lax fiscal policy in country A are significant for country B. Determinacy can be ensured by adopting a ‘passive’ monetary policy in either country A or country B. In both cases, however, lack of fiscal feedback in country A will imply that fiscal shocks have significant macroeconomic consequences for both countries. We examine how the size of these spillovers is influenced by the degree of debt indexation. We also show that the fiscal response required to support an active monetary policy is greater when consumers have finite lives and that the characterisation of ‘active’ and ‘passive’ regimes does not depend on whether or not debt is indexed.