Interactions Between Monetary and Fiscal Policy under Flexible Exchange Rates

Campbell Leith and Simon Wren-Lewis

Working Papers from Business School - Economics, University of Glasgow

Abstract: The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1995), under the heading of the ‘Fiscal Theory of the Price Level’ (FTPL). Applications of this theory to open economies operating under flexible exchange rates has suggested that, in contrast to the closed economy FTPL, insolvent fiscal policy may lead to indeterminacy of price levels and nominal exchange rates. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have independent monetary and fiscal policies. We show that the fiscal response required to ensure stability of the real debt stock, and allow each country to operate an ‘active’ inflation-targeting monetary policy is greater when consumers are not infinitely lived. One monetary authority can abandon its active targeting of inflation to stabilise the debt of another fiscal authority, and there is no requirement that these policy makers operate in the same economy. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when one or more monetary authority is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.

Keywords: Monetary Policy; Fiscal Policy; New Open Economy Macroeconomics; Fiscal Theory of the Price Level (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fin, nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Related works:
Journal Article: Interactions between monetary and fiscal policy under flexible exchange rates (2008)
Working Paper: Interactions Between Monetary and Fiscal Policy Under Flexible Exchange Rates (2003)
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Persistent link: https://EconPapers.repec.org/RePEc:gla:glaewp:2002_11

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