The interplay between monetary and fiscal policy in a small open economy

Øistein Røisland (), Tommy Sveen () and Ragnar Torvik
Authors registered in the RePEc Author Service: Jamie Lee Cross

No No 07/2023, Working Papers from Centre for Applied Macro- and Petroleum economics (CAMP), BI Norwegian Business School

Abstract: We develop a theory for the optimal interaction between monetary and fiscal policy. While one might initially think that monetary and fiscal policy should pull in the same direction, we show within a simple model that this is not always the case. If there are small costs of changing the interest rate, it is optimal that monetary policy and fiscal policy pull in opposite directions when the economy is hit by an inflation or exchange rate shock. The reason is that monetary policy affects inflation through both the demand channel and the exchange rate channel, while fiscal policy only affects inflation through the demand channel. Therefore, monetary policy has a comparative advantage in stabilizing inflation, while fiscal policy has a comparative advantage in stabilizing output. Only when the costs of changing the interest rate are sufficiently high will it be optimal for monetary and fiscal policy to pull in the same direction. We also analyse how tax deduction for interest payments affects the monetary policy transmission. Such an interest subsidy improves goal achievement in response to inflation and exchange rate shocks, but the opposite is true in response to demand shocks.

Pages: 23 pages
Date: 2023-08
New Economics Papers: this item is included in nep-ene, nep-env and nep-ger
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
https://hdl.handle.net/11250/3086068

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bny:wpaper:0119

Access Statistics for this paper

More papers in Working Papers from Centre for Applied Macro- and Petroleum economics (CAMP), BI Norwegian Business School Contact information at EDIRC.
Bibliographic data for series maintained by Helene Olsen ().