Chapter15 - Chapter 15 Monetary-Fiscal Interactions In this...

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© Sanjay K. Chugh 183 Spring 2008 Chapter 15 Monetary-Fiscal Interactions In this section, we briefly explore some issues surrounding the interactions between monetary policy and fiscal policy. In developed countries, monetary-policy-setting is effectively “independent” from fiscal-policy-setting, in the sense that separate authorities control the two types of policy-making. For example, Federal Reserve policy-makers are not the same as Congressional policy-makers. Even in a country where institutional arrangements seemingly insulate monetary and fiscal policy from each other, however, the conduct of each has bearing on the optimal choices of the other. Casual observation makes this point seem relatively obvious – for example, it is not rare to hear a central bank worry about the implications of fiscal deficits for inflation and its consequences for its own policy-setting. There are potentially very many ways in which monetary and fiscal policy interact with each other. One way in which interactions between the two are thought about is using game-theoretic tools. In such an approach, fiscal authorities and monetary authorities are viewed as playing a “game” against each other. Microeconomists have developed rich game-theoretic tools to analyze various aspects of such interactions. Another approach to thinking about monetary-fiscal interactions in recen t years has its grounding the dynamic equilibrium models that have become a staple of macroeconomic theory since the RBC revolution. The focus on the analysis in this approach is on a government budget constraint that involves both fiscal and monetary interactions. We sketch the basic idea behind this second way of considering monetary-fiscal interactions. Before even beginning, we point out that using the RBC-dynamic-equilibrium approach to studying monetary-fiscal interactions is in its infancy. The model we touch on here is likely only the beginning of a large field of research yet to be developed in coming years. In the model, there are two agents: a fiscal authority that controls government spending and taxes, and a monetary authority that controls the money supply. We describe each agent in turn, and then examine how and why they interact with each other, including how which authority gets to “set policy first” has an important effect on the policy choice of the other authority. The Fiscal Authority’s Budget Constraint To describe the fiscal authority, all we need do is specify its flow budget constraint. In period t , the fiscal authority has a flow budget constraint 1 Tb T tt t t t t t Pg B T P B RCB ± ² ² ² . (1.6) From left to right, the terms in this expression are: the nominal amount of government spending ( t g is the real amount of spending); the nominal quantity of government bonds that must be redeemed (i.e., paid back) in period t (which is simply the value of bonds
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© Sanjay K. Chugh 184 Spring 2008 outstanding at the beginning of period t); the lump-sum taxes collected by the
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Chapter15 - Chapter 15 Monetary-Fiscal Interactions In this...

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