Monetary Exit Strategy and Fiscal Spillovers
CAMA Working Paper Series 04/2011
18 Pages Posted: 21 Feb 2011
Date Written: February 21, 2011
The paper models strategic monetary-fiscal interactions in the aftermath of the global financial crisis – in a single country as well as a monetary union. It depicts both the short-term (stabilization) perspective and the long-term (sustainability) perspective, and the link between them. This is done in a game theoretic framework that allows for revisions of actions, deterministic or stochastic. In addition, we consider incomplete information about economic conditions, and different types of government. We find that, under ambitious fiscal policies, a legislated long-term monetary commitment may: (i) reduce the risk of a double-dip recession and deflation in the short-term, and at the same time (ii) facilitate the 'exit strategy' of monetary policy, prevent sub-optimally high future inflation caused by fiscal spillovers. Our analysis thus implies that an explicit numerical target for average inflation may play the role of a monetary 'credibility insurance' over all phases of the business cycle, and is beneficial especially in countries facing fiscal stress.
Keywords: Monetary-Fiscal Interactions, Game of Chicken, Asynchronous Moves, Stochastic Timing, Equilibrium Selection
JEL Classification: E52, C70
Suggested Citation: Suggested Citation