Interactions of fiscal and monetary policies under waves of optimism and pessimism

Paul De Grauwe and Pasquale Foresti

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: In this article we study fiscal and monetary policies interaction under the assumption that agents have limited cognitive capabilities. To this aim, we employ a behavioral New Keynesian model in which agents’ beliefs generate endogenous waves of optimism and pessimism. The role of such waves is studied under three alternative policy setups: fiscal dominance, monetary dominance and no dominance. Output, inflation, government spending and public debt result to be strongly linked to the agents’ beliefs irrespectively of the policy regime. However, under fiscal dominance the system is characterized by more persistent waves of optimism and pessimism. The consequent higher volatility of the system under fiscal dominance also undermines the central bank’s credibility. We show that in order to minimize these negative effects of fiscal dominance, under such a regime governments should focus on public debt stabilization and leave the stabilization of output and inflation to the monetary authority.

Keywords: monetary policy; fiscal policy; beliefs; heuristics; animal spirits (search for similar items in EconPapers)
JEL-codes: E52 E61 F33 F36 (search for similar items in EconPapers)
Pages: 16 pages
Date: 2023-08-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mfd and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Published in Journal of Economic Behavior & Organization, 1, August, 2023, 212, pp. 466 - 481. ISSN: 0167-2681

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Related works:
Journal Article: Interactions of fiscal and monetary policies under waves of optimism and pessimism (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119452

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