Sustainable fiscal policies and budgetary risk under alternative monetary policy arrangements

Abstract

Early work on the theory of economic policy stressed the importance of the interactions between fiscal and monetary policy. Tinbergen, and Cooper, showed us that there would be costs in instability and protracted imbalances, in particular fiscal imbalances, if this was not recognised. Yet most models we use today treat fiscal or monetary policies as if they operated alone. This paper reviews the advantages of recognising those interactions. We consider three possibilities: fiscal leadership (in the sense of acting first), monetary leadership, and simultaneous decision making, each underpinned by independence at the central bank. This temporal separation is important because it creates an opportunity for punishment by the follower (a result from asynchronous games). Making fiscal policy lead, and monetary follow, provides fiscal precommitment and the best results for output, inflation and fiscal balances. In particular, it ensures sustainable public finances without the need for arbitrary (and easily evaded) external restrictions. We show these results are proof against override by rational governments; and robust to changes in structure caused by flattening of the Phillips curve, globalisation, market reforms, and changes in savings.