Fiscal and Monetary Policy Interactions in a New Keynesian Model with Liquidity Constraints

Abstract

This paper derives a New Keynesian dynamic general equilibrium model with liquidity-constrained consumers and sticky prices. The model allows a role for both government spending and taxation in the DGE model. The model is then estimated using US data. We find that rule-of-thumb consumers play a significant role in determining aggregate consumption. Our model is subsequently used to analyse the interaction between fiscal and monetary policies. We demonstrate the extent to which fiscal policy (automatic stabilisers) assist or hinder monetary policy when the latter takes a standard forward-looking inflation targeting form. We also investigate the extent to which inertia in fiscal policy and the existence of rule-of-thumb consumers affect output and inflation variability in the presence of such a monetary policy rule.

JEL Classification: E58, E62, E63