Policy conflict, coordination, and leadership in a monetary union under imperfect instrument substitutability

Abstract

This paper investigates the implications of strategic fiscal-monetary policy interactions on the policy mix and coordination in a monetary union under imperfect policy instrument substitutability. We develop a model that incorporates the key features of the New-Keynesian framework augmented by a cost channel of monetary policy. Both policy instruments can directly affect inflation, hence having supply-side effects, too. We consider alternative strategic and fiscal regimes. We show that relative policy effectiveness and the cost-channel effect together define policy-mix outcomes, policies’ cyclicality, and coordination problems. The cost channel limits union-wide demand shocks’ stabilization, the monetary authority can no longer manage the cycle, and cooperation and commitment irrelevance do not hold anymore. The lead authority reacts to the follower authority's reaction parameter, hence to the follower's preference parameter, while it might choose not to trade-off its objectives. In the leadership strategic regimes for demand-side policy instruments, the leader reacts positively/negatively to the follower's preference parameter, if its instrument is more/less effective in stabilizing inflation (relative to aggregate demand) than the follower's policy instrument.