Monetary and Fiscal Policy Interaction
Active and Passive Regimes
Much of the work in this and the following section has been made possible by three ESRC grants held with Campbell Leith at Glasgow University, under the Evolving Macroeconomy programme, the World Economy and Finance programme, and most recently (2008-11) under the Research Grants scheme. The results of the completed projects were rated as 'outstanding' by the ESRC.
In Leith and Wren-Lewis (2000) we look at simple policy rules within the context of a closed economy model where consumers are non-Ricardian (Blanchard/Yaari) and where there is nominal inertia of the Calvo type. The monetary policy rule has real interest rates responding to excess inflation, and the fiscal rule has taxes or government spending responding to excess debt levels. We show that there are two stable policy regimes in this model. In the first, monetary policy is active (see Leeper(1991)) in the sense that real interest rates rise whenever inflation is above target, and the response of fiscal policy to deviations from steady state debt levels is beyond some threshold level. In the second, monetary policy is passive (so real interest rates fall when inflation is above target) and fiscal policy does not respond sufficiently to excess debt.
This second regime has strong similarities to the Non-Ricardian regime in the Fiscal Theory of the Price level (see, for example, Woodford (2000) and Canzoneri, Cumby and Diba (2001)) An important difference, due to the presence of nominal inertia and non-Ricardian consumers in our model, is that this regime can occur even when all government debt is indexed. In addition, both monetary and fiscal policy influence the price level in both regimes, although the impact of fiscal policy is clearly greater in the passive monetary policy regime (see below).
In two more recent papers, we extend our analysis to a two-country setting, under either a monetary union (Leith and Wren-Lewis (2006) or flexible exchange rates (Leith and Wren-Lewis (2008)). In both cases there exist two stable policy regimes of a similar type to those in a closed economy. However, under EMU, a passive monetary policy is only compatible with fiscal inaction in one of the two countries: if both fiscal authorities take little or no action to stabilise their debt stock, the model will be unstable whatever the monetary policy rule. (This echo's the results outlined in the Canzoneri et al (2001) for non-Ricardian regimes.) There is some scope for compensation between the two fiscal authorities, although the paper suggests that this will be small in practice. Under flexible exchange rates we have two monetary authorities as well as two fiscal authorities, and so now both countries can opearte a passive monetary regime with little or no fiscal feedback on debt. One interesting result in the paper is that a passive monetary policy is one country can compensate for fiscal inaction in the other country.
A special case of passive monetary policy is where nominal interest rates are fixed. The result that a fixed interest rate policy need not lead to price level indeterminacy if fiscal policy is inactive (in the sense outlined above) is not peculiar to rational expectations models. In Leith, Warren and Wren-Lewis (2003) we show that stability is possible under this regime in purely backward looking models, and show in a variety of models that in this passive regime nominal rate shocks may have a surprising impact on the price level.
Two particular issues arise from this work:
how does an economy under a passive monetary policy regime and insufficient fiscal feedback respond to shocks?
This is addressed to some degree in all of our papers cited above, and explicitly in Wren-Lewis (2003). Not surprisingly, both fiscal shocks and demand shocks have a much larger impact in the passive regime than under an active monetary policy. In this sense, the active monetary policy regime appears to be preferable to the passive regime. This result is formalised in Kirsanova and Wren-Lewis (2007) (article, working paper), which finds that welfare in a passive monetary policy regime is always worse than under an active regime.
What does fiscal policy have to do to avoid this regime?
The short answer implied by all the papers noted above is 'not much'. Although Leith and Wren-Lewis (2002) explicitly notes how the presence of non-Ricardian consumers increases the amount of fiscal feedback required to ensure a stable active monetary policy regime, using plausible parameter values this critical speed of fiscal feedback is still fairly slow. Whether more rapid debt adjustment is harmful, or alternatively whether debt needs to be corrected at all, is discussed in a later section.
The Consensus Assignment
Over the last few decades, the general consensus has been in favour of a particular active monetary policy regime, where the stabilisation of output and inflation is the exclusive preserve of monetary policy, while fiscal policy (and only fiscal policy) is concerned with stabilising government debt. (This consensus applies to a flexible exchange rate regime, where interest rates have not hit a zero lower bound.) Kirsanova, Leith and Wren-Lewis (2009) (article, earlier version) refer to this as the 'consensus assignment'. The last ten years has also seen the coming together of two previously distinct branches of academic literature: new Keynesian analysis and dynamic optimal taxation. Kirsanova, Leith and Wren-Lewis (2009) ask whether the consensus assignment is supported by this new research. (Non-technical summary)
Interaction in a Monetary Union
Suppose a national fiscal authority in a monetary union behave in an optimal manner, but cannot commit. The country suffers a positive debt ‘shock’. The lack of commitment technology means that the debt shock will not be accommodated in the long run. However, unlike the closed economy case examined in Leith and Wren-Lewis (2007), Leith and Wren-Lewis (2011) show that the time consistent solution generates a gradual decline in debt because of the need to maintain competitiveness. If the central bank can commit, it adjusts its policies only slightly in response to higher debt, allowing national fiscal policy to undertake most of the adjustment. However if it cannot commit, then optimal monetary policy involves using interest rates to rapidly reduce debt, with significant welfare costs. We show that in these circumstances the central bank would do better to ignore national fiscal policies in formulating its policy.
References
Canzoneri, M.B., Cumby, R.E. and Diba, B.T. (2001) 'Fiscal Discipline and Exchange Rate Systems' Economic Journal, 111, 667-690
Kirsanova, T and Wren-Lewis, S (2007), Optimal Fiscal Feedback in an economy with Nominal Rigidities, Economic Journal (2011) Vol. 122, pp 238-264, also Federal Reserve Bank of Atlanta Working Paper 2007-26
Kirsanova, T, Leith, C and Wren-Lewis, S (2009), Monetary and Fiscal Policy Interaction: The current consensus assignment in the light of recent developments, Economic Journal, Vol 119. (article, earlier version)
Leeper, E. (1991) 'Equilibria under "active" and "passive" monetary policies' Journal of Monetary Economics 27, 129-47
Leith, C. and S. Wren-Lewis (2002), "The Macroeconomic Impact of Different Speeds of Debt Stabilisation in EMU," in Beetsma, R., C. Favero, C. Missale, V. A. Muscatelli and P. Natale (eds), "Fiscal Policies, Monetary Policies and Labour Markets. Key Aspects of European Macroeconomic Policies after Monetary Unification", Cambridge University Press
Woodford, M (2000) 'Fiscal requirements for price stability', J of Money, Credit and Banking