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Monetary Exit Strategy and Fiscal Spillovers

Research Seminars - business and economics


The aftermath of the global financial crisis has seen two types of concerns in regards to monetary policy outcomes. Some (eg Paul Krugman) worry primarily about the short-term possibility of deflation caused by a prolonged slump. In contrast, others (eg John Taylor) worry more about excessively high inflation in the longer-term caused by recent bailouts/quantitative easing and political pressures to monetize intertemporal fiscal shortfalls.

To assess these concerns the paper makes three contributions to the literature:

  1. Our macroeconomic contribution is to model monetary-fiscal interactions jointly over both horizons, and in a sense endogenize Leeper’s (1991) active/passive policy regimes. The focus is on the strategic aspect of the policy interactions under uncertainty about the recovery prospects as observed around the globe in 2010-2011.
  2. Our methodological contribution is to incorporate institutional features such as fiscal rigidity through a novel game theoretic framework. It allows for stochastic revisions of moves and generalizes the Stackelberg leadership concept from static to dynamic. The analysis shows, perhaps surprisingly, that (i) the probabilities of short-term deflation and of long-term high inflation in a given country are positively related, and that (ii) a legislated long-term monetary commitment may reduce both. This is because such commitment (eg a numerical target for average inflation) makes a costly tug-of-war between monetary and fiscal policy less likely. We extend the analysis to a monetary union and show that monetary commitment is less effective due to fiscal free-riding.
  3. 3) Our empirical contribution is to quantify fiscal rigidity and monetary commitment in developed countries, and use them to predict future monetary and fiscal outcomes.


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