Strategic Monetary-Fiscal Interactions in a Downturn

Abstract

Highly diverse responses of monetary and fiscal policies have been observed around the world in the post global financial crisis period of 2010–2014. While some countries implemented various mixes of monetary and/or fiscal stimuli, others have seen austerity. Our paper explores whether the strategic interaction between the central bank and government can shed some light on this diversity, and what lessons about the institutional design of the two policies can be learnt from it. This is done by mapping a reduced-form New Keynesian model into a generalised game-theoretic framework with deterministic and stochastic revisions of policy actions. Our focus is on the short-term policy interaction regarding stabilisation of an adverse shock (rather than long-term issues related to fiscal sustainability and unpleasant monetarist arithmetic). Particular attention is paid to the effect of institutional and structural features such as inflation targeting, monetary and fiscal implementation lags, and the policies’ leadership.