An Examination of How Monetary Policy Influences Fiscal Policy in the Presence of Uncertainty

Doug Hostland and Chris Matier

No 622, Computing in Economics and Finance 1999 from Society for Computational Economics

Abstract: This paper investigates how monetary-policy rules and expectations formation influence the setting of fiscal policy in the presence of uncertainty. The analysis is couched in a stochastic-simulation framework wherein the monetary authority seeks to control inflation while the fiscal authority seeks to control the debt/GDP ratio. We introduce uncertainty in the form of stochastic shocks, which are interpreted as unanticipated economic developments. The stochastic shocks drive the inflation rate and the debt/GDP ratio away from their respective target levels. The monetary authority reacts by adjusting its instrument, the short-term nominal interest rate, in an effort to bring inflation back to its target over a two-year horizon. At the same time, the fiscal authority reacts by adjusting program spending and taxes to bring the debt/GDP ratio back to its desired level over a specified time horizon. Tighter debt control requires larger and more frequent discretionary changes to program spending and taxes and also results in a more pro-cyclical fiscal policy stance. The fiscal authority therefore faces a fundamental trade-off between its debt control objective and its other objectives of stabilisation and tax smoothing. We examine how this trade-off is affected by alternative monetary-policy rules and by the formation of expectations. The credibility of monetary policy plays a key role in our analysis. We explore alternative methods to model credibility as an endogenous outcome of the interaction between the monetary-policy process and the formation of inflation expectations. This includes backward- and forward-looking approaches to modelling long-term inflation expectations ("adaptive" versus "rational" expectations) as well as a simple learning algorithm based on the Kalman filter. Our analysis also considers the scope for co-ordination between monetary and fiscal policy.

Date: 1999-03-01
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